Honeywell International (NYSE:HON) held an investor conference recently, and management outlined its long-term vision for the company. Such events help investors define what they need to know before adopting a long-term buy-and-hold approach toward the stock. Let's take a look at what was said and how it impacts the investment proposition.
Honeywell has good earnings momentum
In the near term, Honeywell's prospects look excellent. The first-quarter results saw the company firing on nearly all cylinders -- a very rare event for an industrial conglomerate -- and its organic sales growth of 8% in the quarter was above its (upwardly revised) guidance for 3% to 6% organic sales growth. It also marked a continuation of the company's pickup in growth in recent years.
DATA SOURCE: HONEYWELL INTERNATIONAL PRESENTATIONS. CHART BY AUTHOR.
However, the question is what kind of growth can Honeywell achieve in the long term, and what does it mean for its valuation?
Honeywell's long-term plans
CEO Darius Adamczyk recently laid out management's long-term plan. The key points are outlined below. For reference, 100 basis points (bp) is equivalent to 1%, so a move from, say, a margin of 10% to 10.2% is an improvement of 20bp.
- Revenue growth at an annual rate of 3% to 5%.
- Segment profit margin expansion of 30bp to 50bp a year.
- Conversion of net income into adjusted free cash flow (FCF) of 100%.
- Dividend growth aligned with earnings growth.
Taking these figures and using the midpoint of guidance for 2019 gives the following scenarios for Honeywell. For reference, the low case assumes 3% revenue growth and 30bp of margin expansion, and the high case assumes 5% revenue growth and 50bp margin expansion.
| Revenue and earnings under different scenarios | 2019 | 2020 | 2021 | 2022 | 2023 | 2024 | Annual growth |
|---|---|---|---|---|---|---|---|
| Low revenue | $36.9 | $38.0 | $39.1 | $40.3 | $41.5 | $42.7 | 3% |
| Low segment earnings | $7.7 | $8.0 | $8.4 | $8.8 | $9.1 | $9.5 | 4.4% |
| High revenue | $36.9 | $38.7 | $40.6 | $42.7 | $44.8 | $47.0 | 5% |
| High segment earnings | $7.7 | $8.3 | $8.9 | $9.5 | $10.2 | $11.0 | 7.4% |
DATA SOURCE: HONEYWELL PRESENTATIONS. AUTHOR'S ANALYSIS.
A few conclusions from these numbers:
First, not many investors will be buying Honeywell stock for its dividend. After all, if the dividend grows in line with segment earnings, then, assuming the high scenario, the $3.28 per share paid out in 2019 will only turn into around $4.70 by 2024 -- equivalent to a yield of 2.8% at the current price of $168.
Second, the low annual earnings growth rate isn't notably above the 2% that investors are assuming for long-term inflation. Most investors would hope that the companies they hold stock in could grow earnings in excess of inflation, particularly because equities carry the risk that earnings growth could disappoint.
Third, the high annual earnings growth rate of 7.4% makes the stock look like good value. If conversion into FCF will be at 100%, then it's safe to assume FCF will also grow at 7.4%. Given that the midpoint of full-year guidance is for FCF of $6.75 billion, then Honeywell will end the year generating 4.8% of its market cap in FCF. That's not a bad valuation for a company that can grow earnings/FCF in the mid- to high single digits.
Putting all this together, Honeywell's long-term guidance suggests you would need to be confident in management's ability to hit the high end of guidance in order to make the stock look like good value.
IMAGE SOURCE: GETTY IMAGES.
Honeywell's growth drivers
Fortunately, there's a good reason to be positive on this front. For starters, Honeywell's segment margin expansion has been rather better than its target of 30bp to 50bp in the past few years. For example, it expanded 70bp in 2017 and 60bp in 2018. Meanwhile, the underlying segment margin is expected to expand 30bp to 60bp in 2019.
Moreover, Adamczyk discussed the possibility of optimizing the portfolio in order to generate margin expansion -- an example of which occurred after the separation of two lower-margin businesses , Garrett Motion (NYSE: GTX) and Resideo Technologies (NYSE: REZI) in 2018. These actions are set to add 80bp to margin in 2019 and, when added to the underlying margin expansion of 30bp to 60bp, it means Honeywell is set to expand reported margin by 110bp to 140bp in 2019.
On top of that, Honeywell is making great strides toward its aim of becoming a so-called industrial software company. The industrial sector is set to be the key beneficiary of growth in the Internet of Things, and Honeywell's "Connected Enterprise" (HCE) initiatives are already bearing fruit. HCE solutions were responsible for $1.5 billion in sales in 2018, and management estimates its connected software sales will grow by 20% this year.
Is Honeywell a long-term buy?
Based on management's guidance, the stock looks undervalued, but not by that much, and anyone buying the stock for the long term should feel confident in management's ability to deliver toward the high end of expectations.
That said, the company's core aerospace end markets look strong, and management has a clear pathway to growth through its digital and IoT initiatives. With a history of good execution and management with a track record of conservatism with guidance, Honeywell should arguably be given the benefit of the doubt for its growth plan. As such, the stock continues to look like good value.
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