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Morningstar | Honeywell Continues to Under-Promise, but Over-Deliver; Raising FVE to $161

Wide-moat Honeywell had a strong start of the year and raised full-year guidance at both the top and bottom end of the range for sales and EPS. Nothing in its first-quarter results alters our long-term view of the firm. We had previously modeled top-line assumptions above management guidance, while modeling segment margins at the top end of guidance. Honeywell has a history of under-promising and over-delivering, and this quarter proved to be no exception. However, we are modeling additional share buybacks to account for the EPS raise on the denominator side. Even so, we are raising our fair value estimate to $161 from $160 previously, based entirely on time value of money. This quarter saw top-line organic growth rise by 8%, with segment profit levels up 9% excluding the spinoffs of Resideo and Garrett Technologies. At today’s prices of around $169 per share (after today’s 4% rise in share price), we believe the market has fully recognized the earning power of this exemplary industrial stalwart.

CEO Darius Adamczyk noted on the earnings call that the company has been deploying a lot of share buybacks because of the current M&A environment, which is "extraordinarily challenging in this environment" given valuations. We agree with this assessment. This lines up with own diversified industrial coverage, which is starting to see many stocks teeter right above our fair value estimates. Adamczyk noted that these repurchase prices last year were at about $150 prior to the Garrett and Resideo spins, which was slightly below our fair value estimate at that time. These purchase price levels suggest share repurchases were mildly accretive. Going forward, however, in our view, most share repurchases to be mostly value-neutral to slightly destructive depending on share prices, based on our go-forward organic assumptions (management would likely disagree).

Some of our hesitation from awarding Honeywell higher long-term growth really revolves around the short-cycle portions of Honeywell’s business, which is harder to forecast given less reliable backlog. Short-cycle businesses include the remaining portions of the home and building technologies segment, as well as key portions of safety and productivity solutions. Indeed, margins in the latter segment contracted by 250 basis points partially because of short-cycle volumes.

By contrast, long-term contracts support the aerospace segment (some span over two decades). Management gave some additional insight in the Boeing 737 MAX by indicating that based on Boeing’s current production schedules Honeywell doesn’t expect any material impact to Honeywell’s 2019 results. One thing we were keen on zeroing in on was any potential working capital impact to Honeywell. Management doesn’t expect any change in the pace of payments typically seen in the business, which is what we’ve been anticipating with Honeywell up to now. We also were looking for the aftershocks on Honeywell’s business after the spinoffs of Resideo and Garrett. Even so, neither the HBT and aerospace segments seem to have had their strides interrupted, with HBT increasing its top line 9% on an organic basis and segment margins increasing 240 basis points to 19.5%, as well as the aerospace top line increasing 10% on an organic basis, with segment margins up 260 basis points. Even though Adamczyk pointed out that the spins were a bit of a distraction and a "heavy lift," the margin accretion management expected is clearly visible in both teams’ numbers.

We agree with management’s view that e-commerce and warehouse distribution trends will continue to be strong secular growth drivers for the firm, and it’s a big part of our investment thesis. At the Automate Conference this month we were impressed with Honeywell’s offerings, which seemed a step ahead with certain features. One piece of equipment, for example, uses an array of vacuum cups that can be used to unload boxes from trucks at warehouse facilities. A key insight we noted from talking with various company and competitor representatives is that Europe is a key region for warehouse automation given stricter labor laws. We expect this to present a great growth opportunity in the United States as well because we expect our own labor regulatory environment to mirror some of Europe’s.