The industrial company has delivered the kind of results for a decade that GE is now hoping to produce.
Long-suffering General Electric shareholders had cause to cheer last month when the conglomerate announced it would shed its finance arm to focus on its core industrial business. Honeywell International investors may have even more reason to celebrate. Through the huge overhaul, GE has indicated that it can deliver 10% earnings growth annually from its industrial side in the next four years, compared with about half that in its previous form. But Honeywell, an established industrial player, remade itself more than a decade ago and has been delivering on promises of 10%-plus profit growth ever since. It expects to continue to generate that level of growth over the next five years, and, based on its record, there’s every reason to believe it.
In contrast to GE (ticker: GE), which saw its shares lose 33% of their value in the past 13 years as its strategy meandered and its massive financial operations foundered, Honeywell’s stock (HON) has risen 200%. Sales have nearly doubled to $40 billion, and its market value has mushroomed to $80 billion from $20 billion.
Honeywell CEO David Cote has made good on his promises. Photo: Gary Spector for Barron's
The Morristown, N.J.–based company has achieved this growth by successfully managing scores of products, ranging from its familiar home thermostats to sophisticated airplane-cockpit controls to security systems and turbochargers.
Having met an aggressive five-year growth plan that ended in 2014, Honeywell has greater ambitions today. “The stuff that we have coming is even more exciting than the stuff we’ve already done,” says David Cote, the outspoken chief executive responsible for revamping and reinvigorating Honeywell since coming on board in 2002. “We do a very good job of ‘seed planting,’ ” says the GE alumnus and onetime contender to succeed former CEO Jack Welch.
With most of Honeywell’s major businesses doing well, its shares, trading last week at $101.58 -- 16.6 times this year’s expected earnings -- could appreciate by about 20% in the next year and by close to 50% longer term. That’s if it continues to live up to its forecasts and to improve margins. After a recent dividend hike, the stock yields 2%. Shareholders of GE, which fetches a premium to Honeywell, face a more uncertain path.
“Whatever GE can grow at, Honeywell can grow faster and with less risk,” says Scott Lawson, portfolio manager and industrials analyst at Dallas-based Westwood Holdings Group, with $20 billion under management. He expects Honeywell to increase earnings by 12% a year in the next three years, based on management projections. “I am making the assumption Honeywell management will perform with the consistency and proficiency they’ve displayed in the past 10 years,” says Lawson.
HONEYWELL DIVIDES ITS BUSINESSES into three segments: aerospace and avionics, which are responsible for 39% of sales; automation and controls, which kicks in 36%; and performance materials, which contributes 25%.
Aerospace is benefiting from new contracts and more flight hours, while avionics has gained market share, aided by strong demand for its cockpit systems. The segment also should get a lift as U.S. defense spending stabilizes and foreign defense budgets expand.
The automation and control unit, which includes heating, cooling, lighting, and security systems for homes and businesses, is expected to grow 4% to 5% annually over the next few years. Commercial sales have been picking up, and demand for “smart” systems and energy-efficient buildings plays to Honeywell strengths.
Even the performance-materials unit, which has been affected by the ailing oil and gas industry, is expected to make a strong contribution. One big opportunity is its Solstice air-conditioning refrigerant, which stands to gain as European countries require new cars to use a low global-warming refrigerant. That should help the group generate 5% to 6% sales growth.
Honeywell is diversified across business lines and geography, with 45% of revenue coming from the U.S.; 32% from other developed countries; and 23% from developing countries, including China and India. More and more, the focus is on emerging markets, or what Cote refers to as “high-growth regions,” where sales are rising by 10% a year.
All of these businesses are tied together by the operating prowess of Cote and his disciplined management team. A process wonk, Cote is a devotee of W. Edwards Deming, an American engineer and management consultant whose theories were adopted by the Japanese following World War II. They are credited as the force behind the country’s postwar economic revival. Cote has sent managers to Toyota car plants in Kentucky to learn more about the production techniques Deming espoused.
Cote’s latest innovation is the Honeywell Operating System “Gold” program, giving more decision-making power to managers at 74 units within its aerospace, performance-materials, and automation-and-control divisions. The idea is to foster a more entrepreneurial culture that’s responsive to customers and gets product to market faster using the support and efficiencies of a large company.
The CEO is best known for his skill in identifying the best mix of high-margin businesses, boosting productivity, negotiating on prices, keeping costs low, and creating a positive, striving culture.
One indication of his management success: Honeywell has supplanted GE as the favorite hunting ground for executive-search firms looking to fill top jobs.
“We are really going to just drive the hell out of growing a lot faster than anybody else,” says Cote of his team’s objectives.
ASIDE FROM THE ABILITY to make things efficiently, Honeywell offers investors a balance sheet with $7 billion in cash, a selective appetite for acquisitions, a commitment to buy back shares under the right conditions, and a dividend that has risen 10 times since 2005. Its pension fund is practically fully funded.
So you can forgive Cote if he sounds like Rodney Dangerfield at times, complaining that his stock doesn’t get the respect Honeywell’s performance deserves.
He points to the company’s relatively strong first-quarter results in a tough environment: Earnings rose 10%, to $1.1 billion -- the high end of guidance -- while operating profit margins expanded by more than two percentage points. The company raised its earnings outlook for the year, to $6 to $6.15 a share from $5.95 to $6.15.
Although sales came in weaker than expected, they still grew 2% on an organic basis. Pinched by foreign-currency hedging and the divestiture of a business, Honeywell reduced its full-year sales revenue forecast to $39 billion to $39.6 billion from $40.5 billion to $41.1 billion. The company maintained its full-year cash-flow guidance of $4.2 billion to $4.3 billion, up from $3.9 billion a year ago. All in all, Honeywell turned in one of the top performances in the industrial group.
“I think we’re underrated based on our financial performance” is a frequent Cote lament and one he reiterated in our recent phone interview. “We have the lowest price/earnings multiple out there.”
At its recent price, Honeywell trades at 15 times 2016 earnings estimates of $6.69 a share (see table below). That’s well below the 17 times that investors assign to multi-industrial companies on average. Competitors such as GE, 3M (MMM), and Danaher (DHR) trade well above 17 times. By comparison, the Standard & Poor’s 500 is priced at 16 times forward earnings, and its earnings growth rate is a relatively paltry 5%.
Some contend Honeywell should command a premium to its peers not only because of its consistent growth but also for its high-margin software capabilities. More than half of its 22,000 engineers are software developers, and many of its advances, such as building management systems and intelligent sensors for offices and homes, are software driven. That gives it the characteristics of a technology stock, says Jon Naimon, of New York–based Light Green Advisors. It’s just a lot cheaper.
Naimon adds that software-based businesses get a high portion of recurring revenue and higher margins than other businesses. “It’s an underrated high-tech company whose software assets aren’t well recognized,” he says. The stock, Naimon says, would be more fairly valued at a multiple closer to Danaher’s, resulting in a price of about $120 a share.
ONE KNOCK AGAINST Honeywell has been that its profit margins fall short of competitors’. But the gap is closing rapidly as it controls costs more tightly and moves into more profitable businesses. Margins have expanded to 16.6% from 13% in 2009 and are expected to approach peers’ by 2018.
Some critics have also groused about the firm’s capital allocation, questioning the lack of acquisitions. In December, it agreed to buy Datamax-O’Neil, a maker of printers used in bar-code scanning, from Dover for under $200 million, but high prices have kept it from making any major purchases in the past 12 to 18 months.
“We’ve come too far in 13 years to all of a sudden lose our minds when it comes to acquisitions,” Cote notes. “I’m going to stay pretty conservative. We will continue to actively look, but we are going to be smart about it, too, because getting the right price makes a difference.”
COTE IS RIGHT about how far Honeywell has come. It was in disarray when he took the reins in 2002, after a merger with Allied-Signal in 1999 (it took the Honeywell name) and a subsequent, failed bid by GE to buy the company.
Cote was recruited from TRW by former Allied-Signal chief Lawrence Bossidy, also a GE alum. Bossidy had come out of semi-retirement to help restore order after the European Commission had scuttled the GE takeover.
Cote tightened accounting controls, brought together warring political factions, and cut costs. Most importantly, he re-established the company’s credibility, most recently by meeting its five-year plan through 2014. Now, Cote and his team are focused on their new plan, which extends to 2018.
At Honeywell’s March investor conference, Cote ticked off a number of goals. He expects 4% to 6% average annual-sales growth from existing businesses, bringing total revenue to $46 billion to $51 billion; an additional $5 billion to $8 billion in revenue could come from strategic mergers and acquisitions. That would result in an extra $1 a share in earnings that could exceed $9 a share by 2018.
If M&A falls short and net cash exceeds $1 billion to $2 billion, Cote is committed to buying back shares to get the extra bang in earnings per share.
Continued operational improvements and cost containment will lift margins by another two percentage points, to 18.5% or more from the 16.6% in 2014. Cote expects Honeywell to generate $30 billion to $33 billion in cash -- $10 billion of that to be paid out in dividends. He’s also targeting a dividend payout ratio of 40%, up from the current 34%.
“The outperformance is going to continue,” Cote vows. Taking him at his word has usually proved profitable to Honeywell shareholders. GE investors can only wait and hope things work out.