Honeywell: 30% Underperformance Creates Opportunities (NASDAQ:HON)

Introduction

In German, there’s a saying that perfectly applies to Honeywell International (NASDAQ:HON): Eierlegende Wollmilchsau.

Essentially, it’s a description for a pig covered in wool (like a sheep) that can be milked like a cow and also lays eggs.

Something like this:

If diversification were an animal, it would probably be this.

Volkswagen even used it in an ad a while ago.

While there are companies with more diversification than Honeywell (Buffett’s Berkshire Hathaway (BRK.A) comes to mind), it has significant aerospace exposure, produces performance materials and technologies, safety and productivity solutions, and building technologies. Each of these segments generates more than $6 billion in annual revenue (using 2022 numbers).

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Having said that, Honeywell isn’t doing so well right now, as shares are roughly 20% below their all-time high.

Furthermore, its shares are down 11% year-to-date. Meanwhile, the S&P 500 is up 16.5%. That’s a difference of almost 30%, leading to one of the worst relative performances since the great financial crisis. Please note that the chart below excludes reinvested dividends.

Although HON is underperforming the S&P 500, it’s reporting strong organic growth in key segments and raising its full-year guidance.

While I cannot make the case that declining economic growth isn’t a reason to be careful when dealing with industrials, I believe that this underperformance isn’t warranted and that HON’s valuation is becoming attractive.

In this article, I’ll give you the details!

What’s Up With Honeywell?

Recent Honeywell headlines are bullish – especially after the company reported strong second-quarter earnings.

As reported by Bloomberg:

“Strength in our overall Aerospace portfolio continues to support Honeywell’s short-term and long-term growth outlook,” Vimal Kapur, who took over as Honeywell’s chief executive officer in June, said in the statement.

According to the company, it not only met but exceeded its commitments thanks to its rigorous operating principles that guided the company through a challenging environment.

• Adjusted earnings per share grew by 6% year-over-year to reach $2.23, which turns into a 13% increase when excluding a non-cash pension headwind of $0.15.
• The second quarter saw a 3% year-on-year increase in organic sales, driven by strength in commercial Aerospace, Process Solutions, and UOP (Universal Oil Products).

Especially Aerospace did very well, with a record backlog of $30.5 billion, a 4% increase year-over-year and 1% sequentially.

Unfortunately, although orders in the Aero segment continued to grow by double-digits organically, other segments experienced a single-digit decline due to unfavorable comparisons with the peak supply chain disruption in the previous year, which brings me to a more detailed overview of the company’s segments’ performances.

After all, even for people who are not invested in HON, getting intel adds tremendous value to the bigger picture – I think.

• Aerospace sales grew 16% organically, with Commercial Aviation leading with more than 20% growth, driven by a recovery in flight hours and deliveries. The aftermarket sector also witnessed remarkable growth, with over 25% growth in Commercial Aviation aftermarket, further boosted by air transport, up more than 30%. Defense and Space also contributed to growth, resulting in 20% year-on-year growth in OE and spare shipments. Also, margins expanded by 120 basis points to 27.7%, which is fantastic, as a lot of aerospace companies are still failing to grow margins.
• The PMT segment saw a solid organic growth rate of 7%, with HPS (Honeywell Process Solutions) and UOP leading with double-digit growth for three consecutive quarters. Process Solution sales increased by 11%, driven by strength in projects and lifecycle solutions. UOP’s growth was fueled by gas processing and refining catalyst shipments.
• Sales for Safety and Productivity Solutions declined by 21% organically, primarily due to declines in warehouse and workflow solutions. If you want more info on warehousing developments, I recently wrote an in-depth article on this topic, which can be accessed here.
• Honeywell Building Technology reported flat year-on-year organic sales in the second quarter. While building solutions grew organically by 2%, the business faced challenges in short-cycle recovery timing. Despite this, the segment executed well in terms of backlog management and achieved a 200 basis points expansion in segment margins to 25.5%.

So far, so good.

With regard to the future, the company’s demand profile remained strong, supported by a record backlog in Aerospace and PMT.

For the third quarter, sales were guided to be in the range of $9.1 to $9.3 billion, which translates to a 1% to 4% growth rate on an organic basis.

The full-year sales outlook was upgraded to the range of $36.7 to $37.3 billion, which reflects a $200 million increase on the low end.

The organic growth range was upgraded from 4% to 6%, with a focus on balancing price and volume. Segment margin expectations were also upgraded, driven by improvements in HBT, SPS, and PMT.

These numbers are also visible in the overview above, which shows that the company upgraded sales growth expectations and margin expectations. This is something worth noting, as most aerospace companies did not increase margin guidance due to supply chain headwinds.

It’s also the reason why I believe that the stock’s massive underperformance is unjustified.

[…] we continue to see sequential improvements and the supply chain environment, and we’re burning down our past-due backlog as expected. – Honeywell 2Q23 Earnings Call

With regard to the organic growth outlook per segment (below), only the SPS segment is expected to see negative organic growth. However, investments in warehouse automation are expected to be near through levels, which is supportive of higher guidance.

This brings me to the valuation.

Valuation

On top of good guidance, the company is expected to accelerate free cash flow after 2023. Analysts expect the company to boost free cash flow beyond $6 billion in 2024, which could result in a 5% free cash flow yield, which not only protects the 2.2% dividend but also indicates a favorable valuation.

HON is trading at 20x 2024E free cash flow, which is a good deal. Before the pandemic, the valuation hovered between 16x and 24x free cash flow, with 20x being the midpoint of that range.

Furthermore, after 2024, free cash flow is expected to continue to grow by double digits.

In this case, I agree with the consensus price target of $221, which is 16% above the current price.

While I do not believe that HON will start a sustainable uptrend before we get a bottom in economic growth, I think the recent underperformance has gone too far.

Although cyclical weakness is clearly visible in some segments, the company is seeing strong growth in Aerospace, improvements in supply chains, and higher-than-expected sales and margin guidance.

Once economic growth bottoms, it’s likely this well-diversified industrial stock will generate strong outperforming results, making it a great investment for long-term (dividend growth) investors on weakness.

If I didn’t have so much industrial exposure already (including 20% aerospace & defense), I would accumulate HON shares on weakness before it potentially moves higher with support of higher economic growth.

Takeaway

Honeywell International, which can be seen as an Eierlegende Wollmilchsau of diversification, boasts advanced businesses, including Aerospace, performance materials, safety solutions, and building technologies.

Despite its recent underperformance, with shares down 20%, Honeywell’s strong organic growth, record backlogs, and raised guidance underscore its resilience.

Especially its Aerospace segment shines with an impressive expansion in margins and backlog.

While economic uncertainty persists, Honeywell’s attractive valuation, trading at 20x 2024E free cash flow, and projected double-digit growth in free cash flow beyond 2024 indicate a favorable outlook.

This well-diversified industrial powerhouse is trading 16% below its fair value after underperforming the market by 30%, making it an attractive option for patient, dividend-focused investors seeking long-term gains, especially when economic growth rebounds.