There’s a case for arguing that Honeywell International (HON 0.33%) is a victim of its success, and that success is creating pressure on management to change its strategy. While it may sound like an oxymoron to change a winning strategy, shareholders always want improvement, and the company’s lofty valuation rating means management is under pressure to generate more value for investors. But does it all add up to make the stock worth buying this year?
Honeywell’s valuation “problem”
The industrial conglomerate is a high-quality company, and the market knows it. While it’s fair to say industrial conglomerates are hardly in vogue these days, Honeywell’s valuation suggests the market does think it’s different.
The market has good reason to think this way. Honeywell’s mix of businesses ensures consistent growth across a range of market conditions, with management targeting 4%-7% annual revenue growth over the long term. In addition, targeted annual segment margin expansion of 40 basis points (bp, where 100 bp= 1%) to 60 bp will result in something close to double-digit earnings growth.
On top of that, management believes its exciting collection of so-called “breakthrough initiative” businesses (including quantum computing, green hydrogen technology, avionics, and propulsion systems for air taxis and cargo drones) can contribute an additional 1%-2% of organic growth. That said, realizing the value of the breakthrough initiatives will take time.
Is it enough to justify buying a stock trading on the current valuations shown in the chart or the forward P/E ratio of 20 that Wall Street analysts have penciled in? It’s debatable, and the stock price is down 6.7% over the last year, as the market has discussed this.
HON EV to EBITDA data by YCharts
More growth, or a change of narrative?
The answer to the question is for management to improve its growth rate or try repositioning the company to release value for investors. Management appears to be trying to do both.
Having been criticized for not being aggressive enough in allocating capital toward mergers and acquisitions, management appears to be adjusting its approach. The criticism is justified, in the author’s opinion, because one of the critical benefits of the industrial conglomerate structure and running a conservative balance sheet is the ability to deploy cash to add growth through acquisitions when prices are attractive.
The $4.95 billion deal (in line with management’s intent to make deals in the $1 billion to $7 billion range) to buy Carrier‘s global access solutions business for 13 times earnings before interest, taxation, depreciation, and amortization (EBITDA) and add it to Honeywell’s building technologies businesses is a step in that direction.
Image source: Getty Images.
Moreover, management’s segment restructuring will create four new reporting segments — industrial automation, building automation, aerospace technologies, and energy and sustainable solutions — themed around megatrends that investors might warm to.
The restructuring does two things. First, it makes it easier for the company to separate and spin off one or more segments if the conditions are right.
Second, it changes the narrative around the stock. Instead of asking how you would value a diversified industrial conglomerate, investors might argue that aerospace, automation, and sustainable energy stocks tend to carry valuation premiums, so Honeywell’s sum of the parts is worth much more than the current valuation.
That narrative will be amplified if valuations in the industrial automation sector (or one of the other segments) get hot and the clamor for Honeywell to release value by spinning a business off grows louder.
Image source: Getty Images.
What’s next for Honeywell in 2024?
It wouldn’t be surprising for Honeywell to explore spinoffs and portfolio restructuring in the future. After all, three of its peers and rivals have already taken that route. Emerson Electric has gone “all in” on automation and associated technologies; General Electric’s break-up will leave the remaining company focused solely on aerospace; and Carrier, Otis, and half of RTX used to be part of the former United Technologies.
Other than that, Honeywell looks set for mid-single-digit revenue growth and high-single-digit earnings growth in 2024. On a positive note, its long-term growth potential looks assured, even if its current acquisitions are unlikely to move the needle much.
Still, the stock always has the upside kicker of value-enhancing spinoffs, and the long-term coming to fruition of the breakthrough initiatives. There’s nothing wrong with paying a premium for a quality business
That said, based on the current valuation, it’s probably not enough to justify buying the stock for most investors, but Honeywell is definitely a stock to pick up on any significant weakness.
