PH - Honeywell Lagging A Bit Despite Consistent Performance

Summary

• Honeywell's fourth quarter results were largely typical of the larger industrial sector and basically in-line with expectations, though with a modest segment-level earnings beat.
• Management guidance for FY'23 was perhaps more cautious than investors expected given its later-cycle leverage, but close to 40% of the business could arguably be called short-cycle.
• Aerospace should remain an area of strength, as should building automation, but warehouse automation, sensing, Productivity Solutions, and Advanced Materials could see some pressure in 2023.
• There will always be a lot of moving parts to the Honeywell story, but I expect 5% long-term revenue growth and 10% FCF growth, and the shares are back to a more reasonable valuation.

The market is a curious place at times. Given more modest exposure to short-cycle uncertainties, I’m a little surprised that Honeywell ( HON ) is down about 10% since my last update and has underperformed the broader industrial group. Granted, I thought Honeywell was fully-valued at the time of that last update, but I didn’t expect to see the market rotate at least partly back toward shorter-cycle names on increased confidence that any 2023 slowdown won’t be as severe.

There are a few areas at Honeywell that look soft in the near-term, and guidance for 2% to 5% organic growth wasn’t particularly exciting, though I also think it was a conservative guide. I’m actually surprised to see that, relative to my expectations, Honeywell actually looks pretty attractive on a relative basis. Maybe my long-term growth assumptions for revenue (5%) and free cash flow (10%) are too high, but the valuation today looks like a potential buying opportunity.

A Quick Look Back At Q4 Results

All told, I’d say Honeywell’s fourth quarter results were pretty typical for the industrial sector. Revenue was a little light of expectations, but 10% growth was pretty much in line with the group. Likewise, while operating earnings were a little shy of expectations (up 8%, with margin 50bp to 22.6%), segment-level profits beat by 4%, with margin up close to 2 points (to 24.1%).

Honeywell’s Aerospace segment did alright, with 20%-plus growth in commercial aerospace right up there among the leaders (and ahead of other multi-industrials like Eaton ( ETN ) and Parker Hannifin ( PH )), and the 3% decline in Defense and Space wasn’t atypical for the quarter either.

Safety and Productivity Solutions (down 3%) was weaker than expected, but it wasn’t as though management didn’t warn the Street about weakness in Intelligrated’s warehouse automation business and tough comps in Productivity Solution and Services were already evident. Relative to a broad range of comparables like Brady ( BRC ), Cognex ( CGNX ), and Zebra ( ZBRA ), performance was mixed, though a decline in low-margin installation business helped margins (up almost 10 points to 20.2%).

Building Tech saw 16% revenue growth that was consistent with ongoing retrofit activity in commercial buildings and market conditions as seen by others like Carrier ( CARR ), Johnson Controls ( JCI ), and Trane ( TT ). Last and not least, Performance Materials and Technologies (up 15%) is tougher to benchmark, but did beat expectations and comps like Emerson ( EMR ).

Caution Makes Sense, But Honeywell Should Be Okay

I can appreciate the virtues of conservative guidance at this point, and I’d note that the managements of companies like Dover ( DOV ) and Eaton have been relatively cautious with their initial guidance for 2023. Add Honeywell to that list, as I don’t think 2% to 5% organic revenue growth guidance when there should be a 4%-plus tailwind from price is particularly ambitious.

Depending upon whether you consider commercial aerospace aftermarket as “short-cycle”, Honeywell’s short-cycle exposure is around 25% to 40% of revenue. In my opinion, it kinda is … and it kinda isn’t. Looking at this specific cycle, jobs and wages are healthy and seem likely to remain so, so I don’t think there will be that much pressure on air travel demand. If I’m wrong, though, and we see a deeper/longer down-cycle, there will be eventual repercussions to air travel demand and Honeywell’s aftermarket business (though likely more a 2024 driver).

As far as the other short-cycle businesses, I’d expect Building Tech to hold up well on retrofit demand, while sensing and Productivity Solutions will likely be softer. Advanced Materials, too, will probably see some pressure, though I still see healthy momentum in areas like Solstice.

Overall aerospace demand should be stronger in 2023. I expect ongoing recovery in commercial aerospace builds; bizjet momentum may start to fade some, but commercial narrowbody demand should help offset that, and management has called for a trough in Defense and Space after eight straight quarters of contraction. One item of note – stronger original equipment sales can be a mixed blessing, as they are typically bad for margins given the rebates Honeywell gives to Airbus ( OTCPK:EADSY ) and Boeing ( BA ).

This year is also likely to be tough for the warehouse automation business, particularly with Amazon ( AMZN ) cutting back on spending and Prologis ( PLD ) looking for a significant decline in new warehouse starts in the year. I’d also expect some moderation in sensing and process automation, though healthy demand from longer-cycle industries (like oil/gas and petrochemicals) may smooth that over to some extent).

Longer term, I’m bullish on some less-discussed parts of the Honeywell story like UOP and Connected Enterprise. UOP is usually just talked about in the context of its refining catalyst and gas conditioning products, but there’s a “skunkworks” aspect to this business, with the company working on a range of technologies applicable to batteries (including long-duration flow batteries), carbon capture, and renewable fuels (like hydrogen and biofuels).

On the Connected Enterprise side, there’s more going on here in terms of digitization, automation, and cybersecurity – Honeywell is increasingly integrating sensors and software into highly-automated monitoring solutions, while Forge Performance+ is automating asset tracking and performance management. There’s also a cybersecurity angle here, as Honeywell’s capabilities in machine controls and software enable customers to spot cyberattacks earlier by detecting anomalies in operating system performance.

The Outlook

It could be the case that some of Honeywell’s underperformance is tied to the fact that it straddles both short-cycle and longer-cycle markets. Aerospace is a well-understood multiyear recovery opportunity, as is building electrification/automation, but businesses like Productivity Solutions and Advanced Materials do still tie the company to the economic cycle to some extent.

In any case, I’m looking for modestly below-trend revenue growth in FY’23, but stronger results in FY’24-FY’26 and longer-term annualized revenue growth near 5%. These aren’t new expectations; my FY’31 revenue estimate has changed by less than 1% since my last article.

My margin outlook is actually a little stronger now, and I think Honeywell will see EBITDA margin improve from around 25% in FY’22 to close to 27% in FY’25, and I expect similar improvement in core operating margin. At the free cash flow line, I expect margin to improve toward 20%, driving 10% long-term FCF growth.

Honeywell isn’t exactly “cheap” on discounted cash flow, but more like “about as cheap as it gets”. Likewise, the shares aren’t undervalued by much on an EBITDA basis (using a forward multiple of 15.25x), but the shares have traded at premiums here quite often.

The Bottom Line

I think there’s a relative value argument to be made for Honeywell now. I do think a robust valuation could explain some of the underperformance (investors cycling out of Honeywell in favor of cheaper/lagging names), but I think the process has moved the shares back to a more interesting level. Provided you find mid-single-digit revenue growth and ongoing margin improvement plausible, these shares are worth a look again at today’s price.

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