Honeywell Comes Through, But Valuation Isn't So Sweet

By Stephen D. Simpson, CFA | January 30, 2013 AAA

What a difference a month or so makes. With investors happy to see Congress play kick the can with the fiscal cliff, industrial stocks have caught a second wind and done quite well over the last month. While Honeywell (NYSE:HON) is a quality industrial conglomerate that often seems to get overlooked, management's modest guidance for 2013 and the company's mediocre free cash flow history don't really argue for aggressively chasing these shares at this point.

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Solid, Albeit Not Spectacular, Performance for Fourth Quarter
Honeywell reported a very respectable result for the fourth quarter of 2012. Management stayed true to form, however, in acknowledging some signs of end-market improvement, but maintaining guidance that on the whole looks fairly conservative.

Revenue rose 1% as reported and 1% on an organic basis. Automation and control systems (ACS) was the performance-leading division, with organic revenue growth of 3%. Aviation was a little softer than expected, with organic revenue down 1%. Performance materials grew 8% on an organic basis, while transportation dropped 11%.

Adjusted gross margin was basically flat with the prior year, while operating income rose about 9%. Segment-level profits rose a little more than 5%, with ACS logging a 10% improvement and aviation growing 5%, while performance materials and technologies (PMT) fell 6% and transportation dropped 20%. The good news, in brief, was that Honeywell saw the best performance from the segments that generally count the most.

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The Comps Get Interesting
Comparing Honeywell to some of its leading competitors produces some interesting data and deviations. While General Electric (NYSE:GE) saw good growth in its aviation business, Honeywell is far more exposed to defense (which fell 6%) and aftermarket parts, and that very definitely kept a lid on performance.

Honeywell's performance in ACS was also interesting. Honeywell definitely outperformed rivals like United Technologies (NYSE:UTX) and Johnson Controls (NYSE:JCI), helped at least in part by its exposure to security and environmental. Process solutions was soft, but still better than recent results from Parker Hannifin (NYSE:PH) or Siemens (NYSE:SI) might have suggested. It will be interesting, then, to see what companies such as Rockwell Automation (NYSE:ROK) and Emerson (NYSE:EMR) have to say about these markets, and likewise Tyco (NYSE:TYC) in its security business.

Transportation has also gotten very tough for Honeywell, with European light vehicle production down about 10% in the fourth quarter. Although BorgWarner (NYSE:BWA) and Honeywell's transportation business don't necessarily move in lock-step, they tend to go in the same direction at similar paces, so this doesn't suggest an especially strong quarter for BorgWarner.

Guidance Still Conservative
Honeywell tends to be a fairly conservative company, and that shows in the guidance. Management is looking for only low single-digit revenue growth this year, with good growth in PMT and decent growth in ACS pulled down by weakness in aerospace (due in large part to defense) and transportation. While it's tough to see how defense really surprises to the upside this year, it may not be as bad as was feared, while increased turbo penetration into the Chinese vehicle market could offer some upside.

Apart from that guidance, Honeywell still has ample room for improvement. The company's operating margins are not all that impressive relative to many other industrial conglomerates, and this explains a lot of the company's relative underperformance in free cash flow production. While bears could use that as a reason to avoid the shares, it also represents profit potential that could be unlocked down the road if management focuses on generating better returns.

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The Bottom Line
As I have said earlier in this piece, there's a push and pull when it comes to Honeywell and its shares. The company likely could do better than it does, but how much credit do you give for potential? Likewise, while the company has some good market exposures, the overall growth profile doesn't look so impressive in the short term.

Assuming that Honeywell can generate high single-digit free cash flow growth (against mid-single digit performance over the past decade), these shares carry a fair value in the low $70s. That's not really enough to get me excited about these shares, particularly after their recent run.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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