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Morningstar | Honeywell Continues Reliable Performance While It Prepares for Resideo Spin-Off

Wide moat-rated Honeywell turned in another strong performance today, and we maintain our $168 fair value estimate. Management provided key updates on both the timeline and impact of the Resideo Technologies spin. This business was previously booked under "homes" within the firm’s home and business technology segment. The spin-off (in the form of a special dividend) is expected to take effect on Oct. 29. Investors will recall that Honeywell already completed the spin-off of Garrett Motion, the firm's automotive turbo engine business that competes against the likes of narrow moat-rated BorgWarner, within our coverage. That business was previously booked under "transportation systems" within the firm’s aerospace segment. While we’ve made some slight adjustments in our model based on the timing of the spins, as well as some other puts and takes based on the performance of certain businesses for the year, our fundamental outlook remains unchanged. We still believe Honeywell is one of the highest-quality and best-managed industrial names in our coverage, underpinned by both our wide-moat and Exemplary stewardship ratings. At the current market price of $155, the stock trades at about an 8% discount to our fair value estimate, and management has reliably bought back shares when they believe the stock is undervalued (as they do now).

A couple of businesses stood out to us in the media release for exceptional year-to-date and quarterly performance. First, the aerospace segment continues to impress. Specifically, both Honeywell’s commercial aerospace original equipment and defense and space business have run ahead of our expectations for the year. Defense, for example, grew 14% organically year over year. On the call, management indicated that U.S. Department of Defense spare parts volume, robust sensors, and guidance systems drove demand, as well as higher volumes on key programs, like the F-35 and CH-47 Chinook. CEO Darius Adamczyk expects the momentum in defense to continue, driven by the same tailwinds. We’re expecting additional benefits that we suspect the market is not baking in currently. Our in-house U.S. aerospace analyst currently forecasts about a 2-point-greater spread in defense market revenue growth versus the rest of the market's forecast, according to data from Capital IQ. We recently incorporated this into our assumptions (over 7% year-over-year growth at Morningstar versus 5% for the rest of the market).

That said, we don’t think the original equipment outperformance of double-digit year-over-year revenue growth is a new normal for the business. We currently model mid-single-digit growth in this portion of the business. These are tough comparisons going into next year, and Adamczyk himself noted original-equipment aero may be the only place where he is "a little bit nervous." Even so, we still think this a wide-moat, reliable long-cycle business given the robust order book and backlog. Management indicated on the call that total firm long-range orders and backlog were up 26% and 17% year-over-year, respectively.

Adamczyk also called out the firm’s acquisition of Transnorm in our favorite high-growing business of warehouse automation. We think this business’ outperformance will continue driving the stock toward our fair value estimate. Warehouse automation for e-commerce accounts for 90% of Transnorm’s business (annual sales of about EUR 100 million). We think the firm’s focus on warehouse automation confirms our thesis that e-commerce package volumes will continue propelling the business forward. Intelligrated, which Honeywell acquired in 2016 and gave Honeywell its strong footing in the space, was a customer of Transnorm. The company fits in well with the Honeywell portfolio given its differentiated technology, intellectual property, installed base, and high aftermarket and services component. We also like that it allows Honeywell to expand its geographic footprint into the European market, where e-commerce is also growing.

Finally, although there have been headwinds with transaction costs as management enacts two spins nearly simultaneously, we’ve been impressed by the firm’s working capital management, which we believe should allow for near-100% free cash flow conversion. And while tariffs may certainly be a headwind next year, one thing we’ve always liked about Honeywell is its emphasis on local supply chains.