Honeywell Is Popular, But Built To Perform Well

By Stephen D. Simpson, CFA | June 07, 2013 AAA

For the most part, I try to avoid buying stocks where the company is already pretty popular with the Street. Sell side analysts have a tendency to pick horses and then ride them into the ground with “the stock is at my target, so I'm lifting my target” types of calls. In the case of Honeywell (NYSE:HON), though, I can understand why this industrial conglomerate is basking in some Wall Street love. Not only is the company well-positioned to take advantage of some major long-term global trends, but R&D investments made years ago should start bearing fruit and the company may yet have more margin leverage left at a time when so many industrials may be peaking.

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Urbanization, Efficiency, And Pollution Control Aren't Fads
It happened a long time ago in the U.S. and Western Europe, but major emerging markets can still look toward ongoing urbanization. With that will come more demand for the HVAC and building control products that Honeywell makes, as well as products for worker safety, security, and manufacturing facilities. At the same time, energy efficiency and pollution are becoming more important around the world, feeding demand for Honeywell's control products, specialty chemicals/performance materials, and turbochargers.

One of the challenges for Honeywell will be to expand its global footprint to really take advantage of these opportunities. In some respects Honeywell has been a more North America/Western Europe-focused company relative to competitors like Emerson (NYSE:EMR), Siemens (NYSE:SI), and General Electric (NYSE:GE), and that needs to change to really take full advantage of these trends. Working in Honeywell's favor is that emerging market urbanization and global efficiency/pollution control are trends that will stretch over a decade (if not several decades), and there's time.

Leveraging R&D Into New Opportunities
It sometimes feels as though institutional investors obsess so much over margin leverage and capital distributions back to shareholders that they lose sight of the fact that it takes money to make money – specifically, investments into R&D are vital to maintaining (or improving) long-term competitiveness. To that end, investments made in years past should start paying off for Honeywell in the coming years.

Thanks to companies like United Technologies (NYSE:UTX), Garmin (Nasdaq:GRMN), and GE, commercial aerospcae is an increasingly competitive space at all levels of the market. The acquisition of Goodrich has helped increase UTX's potential share of aircraft value to around two-thirds (versus about one-third to 40% for Honeywell), but R&D directed into propulsion systems, environmental controls, and avionics (including a new near-to-eye display that works like a heads-up display) should keep Honeywell very much in the game.

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The company's performance materials division also offers an opportunity to leverage R&D investments. Honeywell already has a large flourine business, but the launch of Solstice, a new automotive air conditioning refrigerant developed over many years with DuPont (NYSE:DD) could be a multi-billion dollar long-term opportunity. Likewise, products aimed at gas-to-chemicals conversion, heavy crude refining, and electronics could all deliver better revenue (and margins) in the not-so-distant future.

In truth, probably every segment of Honeywell can look to leverage past R&D investments. Honeywell's automation business has strong industrial wireless capabilities, and that market has attracted more attention from the likes of Emerson and ABB (NYSE:ABB) recently as a long-term growth market. In the transportation business, Honeywell is a technology leader in turbocharging and new products should drive future share gains in crucial markets like China.

The Bottom Line
I do believe that the Street has put too many eggs in the basket that says we'll see a big second half recovery in industrial demand. Should that enthusiasm prove unfounded (or even just excessive), most industrial conglomerate stocks will suffer, and I wouldn't expect Honeywell to be any different. For long-term investors, though, very little would change as there's little about the Honeywell bull thesis that really relies on a quick recovery in the global markets.

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I expect Honeywell to grow revenue at a long-term CAGR of between 4% and 5%, with strong margin leverage and cash conversion improvement leading to a much higher 10% free cash flow growth rate. Clearly I'm expecting meaningful improvement here, so if Honeywell's above-average margin leverage of recent years fades, there will be downside to those projections. Assuming Honeywell delivers, though, fair value is in the mid-to-high $70s. With Wall Street's enthusiasm for Honeywell having pushed the shares above that level, it's not necessarily a compelling buy today, but definitely a name to consider if or when the markets retreat further.

At the time of writing, Stephen D. Simpson owned shares of ABB.

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