Honeywell Better-Placed Than Most To Take On Next Year's Challenges

In a market that is increasingly worried about what 2023 will hold for the global economy in general and short-cycle industrial markets in particular, Honeywell (NASDAQ:HON) stands out. There are a few parts of Honeywell's business that likely won't be at their best next year, but a solid two-thirds of the business should be seeing strong demand at a time when many other quality industries will be struggling with weaker conditions.

When I last wrote about Honeywell, I lamented the Street's fickle treatment of the shares and thought it was a name to consider if the shares pulled back further. While the shares are now up about 5% from that time, investors did have two opportunities to pick up shares in the $170s (or about 15% below today's price). Right now I see a bit of a split between the valuation and the secular appeal of the shares - I don't see the stock as all that cheap (it seldom is), but I do think it is better placed than most, and could earn a sustained premium to its peers through 2024.

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 Honeywell Better-Placed Than Most To Take On Next Year's Challenges

Honeywell Underperforming As Wall Street Once Again Shows It Will Eat Its Darlings

 

Whatever may be the apple of Wall Street’s eye today, it’s a safe bet that the clock is ticking on how much time is left before it's relegated to apple sauce in the cafeteria. That would seem to fit the recent performance of Honeywell (HON), as what was one of the more popular large multi-industrials earlier in the cycle has underperformed the space by about 10% since my last update and now sports quite a few more “hold/neutral” ratings than before. I understand this … to a point. Honeywell benefited from a run back to names leveraged to aerospace and process automation, as well as warehouse automation and building controls, and there were expectations of more capital deployment. Now, though, the aero and process cycles are known entities and the Street is looking for names with more near-term sizzle.

Valuation is still a concern; while Honeywell’s valuation has shrunk more than its sector, sector valuations are still above long-term averages and I am concerned that there could be further contraction. I’m not worried about the quality, though, and this is a name to consider if this slide continues.

 

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Honeywell Underperforming As Wall Street Once Again Shows It Will Eat Its Darlings

Honeywell About To Emerge As A Multiyear, Multi-Theme Growth Story

 

I’ve always been of the belief that sooner or later valuation matters, and I do believe the somewhat “robust” valuation of Honeywell (HON) explains why the shares have slightly lagged the larger industrial group in the six months since my last update. This comes despite an emerging shift toward longer-cycle names and a set-up for Honeywell that I believe has the company well-placed for at least three to four years of above-peer growth, with attractive exposures to a variety of appealing end-markets.

I’m not arguing that Honeywell is fundamentally cheap – this is much more of a directional/secular call than a valuation call. What’s more, the industrial sector trades at multiples above where it historically has relative to margins, ROIC, et al (low rates certainly help). In an “everything is expensive” market, though, I think Honeywell should trade at more than a 10% or so premium to the average industrial’s ’22 EV/EBITDA multiple, and even though I don’t like the long-term prospective returns, these shares could still be a relative outperformer as the longer-cycle opportunities emerge.

 

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Honeywell About To Emerge As A Multiyear, Multi-Theme Growth Story

Honeywell In Recovery Mode, But Valuation Is Tough

It’s entirely normal for the Street to anticipate recoveries, running the stocks ahead of actual turns in the year-over-year results. So while I’m little surprised to see the magnitude of Honeywell’s (HON) outperformance over the past six months, a lot of that has to do with expanding multiples across the industrial space, as actual earnings revisions haven’t been quite so powerful.

Valuation is problematic. I think Honeywell is a very well-run company with a lot of attractive long-term opportunities. The reality, though, is that the S&P 500 screens as historically expensive by most metrics (PE, P/BV, EV/EBTIDA, P/FCF, et al), and the industrial sector is a little expensive to the S&P 500 relative to historical norms (about 10% or so). On top of that, Honeywell doesn’t screen as a particularly cheap industrial relative to its peers. With prospective returns in the mid-single-digits, I think there are better names to consider.

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Honeywell In Recovery Mode, But Valuation Is Tough

Honeywell Facing Significant Margin And Recovery Uncertainty, But Quality Provides Support

Nobody knows exactly how the next 24-36 months are going to play out, particularly with respect to whether we see a V-shaped, U-shaped, or L-shaped recovery, but I feel confident in predicting that when the dust settles, Honeywell (HON) will still be an excellent company. I realize that may sound trite, but I think a company’s ability to make good decisions and generate long-term shareholder value can be overlooked when investors are freaking out about all of the uncertainty in the global economy.

I still believe that Honeywell has elevated margin risk, but I think that’s a little better-appreciated now. I am also still concerned about the recovery prospects for Honeywell’s longer-cycle businesses, which contribute about 40% of revenue. The shares have underperformed slightly since my last update and remain in a valuation grey zone. I’d be in no hurry to sell if I owned then, and the prospective return is decent (high single-digits), but I think there are better risk-adjusted opportunities; getting another chance to buy below $120 would be a different story and that’s something to watch for if there’s another pullback.

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Honeywell Facing Significant Margin And Recovery Uncertainty, But Quality Provides Support

Honeywell Looks Vulnerable To Sentiment And Margin Shock, But Still Attractive

The grim reality is that nobody really knows anything right now when it comes to assessing the impact of Covid-19 on the U.S. economy (let alone the global economy), nor how long it will take to get back to business as usual. While the market has recovered pretty strongly over the last couple of weeks, taking Honeywell (HON) shares up more than 40% from the point of peak panic, I don’t necessarily think we’ve seen the last shoe drop. Given the difficulties in predicting end-market demand in this environment, I’d be surprised if Honeywell didn’t pull guidance entirely. I also see a risk of sharp decremental margins – probably not in the first quarter, but possibly in the second and third quarters – and I believe that may shock the Street and rattle sentiment again. On top of that, a significant chunk of Honeywell’s revenue looks to me to be at risk beyond just a sharp correction that resolves by year-end.

All of this doom and gloom aside, these are the times that value investors wait for. Honeywell’s valuation isn’t quite where I’d like to be after this strong rally, but it’s good enough for this as a long-term holding and certainly at a level where I’d watch this for any potential “double-dip” in the industrial sector as companies start reporting March quarter earnings.

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Honeywell Looks Vulnerable To Sentiment And Margin Shock, But Still Attractive

Honeywell Comes Through On Margins, But Growth Lagged A Bit

I have to admit that Honeywell's (HON) lackluster share price performance over the past three months has surprised me, as I expected this well-loved multi-industrial to benefit from some "safe haven" investment flows as the data on a broader industrial slowdown continued to accumulate. Whether I underestimated how much of that had already taken place, or whether investors were a little put off by valuation, I don't know, but Honeywell has lagged its industrial peers a bit since the second quarter earnings update, though the company is still among the outperformers of the past year.

There wasn't really anything in Honeywell's third quarter that changes my view. The company's longer-cycle process businesses are holding up and aerospace should remain strong for some time. Weakness in productivity/automation should be transitory, and the company continues to do well on margins. Healthy mid-single-digit long-term FCF growth and strong margins/ROIC/ROA support a robust valuation for Honeywell shares, but I can't call these shares undervalued today.

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Honeywell Comes Through On Margins, But Growth Lagged A Bit

Honeywell Living Up To Its Safe Haven Reputation

In a quarter where it has becoming increasingly clear that short-cycle industrial markets are slumping and long-cycle markets are starting to wobble, Honeywell’s (HON) steady performance and minor beat-and-raise for the second quarter certainly solidifies the safe haven credentials that have been part of my bullish thesis on the stock. With a strong Aerospace segment and steady performance in Building Tech and PMT offsetting temporary weakness in Safety and Productivity, there’s not much that concerns me about the performance for the company.

What does concern me is the valuation. Although Honeywell has modestly outperformed industrials since my last update, almost all of that outperformance came in the post-earnings jump. Moreover, I’m concerned that we’re going to see a downward revision cycle after this earnings reporting cycle across industrials and a reset in valuations as investors accept that the second-half rebound thesis is looking pretty shaky. I do believe that Honeywell’s valuation could continue to exceed historical norms as institutions flock to own one of the few industrial stocks that’s “working”, but I don’t like playing the game of assuming that above-trend valuation will continue to expand at a time when the sector is seeing downward re-ratings.

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Honeywell Living Up To Its Safe Haven Reputation

New Tariffs Create New Headaches For Rockwell Automation

At the time of Rockwell’s (ROK) fiscal second quarter earnings report in late April, I commented that I thought investors would have an opportunity to buy shares in this high-quality automation enabler at a lower price. Since then, the shares have dropped more than 15%, significantly underperforming industrials in general, on growing concerns about a slowdown in the industrial end-markets that make up a large part of the discrete automation market. Now with the prospect of significant tariffs on Mexico on the table, Rockwell is taking another body-blow.

I do believe that Rockwell management is underestimating the risk of a broader slowdown in industrial end-markets, even though I do basically agree with its more bullish medium-to-long-term outlook. With a real risk of a “lower-for-longer” end-market demand situation and now potential pressures from new tariffs, I’m inclined to keep waiting even though Rockwell shares now trade below my estimate of fair value.

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New Tariffs Create New Headaches For Rockwell Automation

ITT Overlooked And Undervalued As A Late-Cycle Play

I'm not sure it's entirely appropriate to call a stock followed by over a dozen sell-side analysts and widely-owned by institutions "overlooked", but I don't get the sense that ITT (ITT) is as widely-known among investors as it should be. And, that's a shame. ITT isn't perfect, but I like this diversified industrial's philosophy of adopting best practices irrespective of their source, not to mention broad late-cycle exposure and a strong growth auto business.

Below the mid-$60s, I think ITT is undervalued. While there is some asbestos liability here, I believe it is well-covered, and the company has the dry powder available to make select acquisitions to build out its operations further. I believe the perception of the auto business has already corrected, and ITT's short-cycle industrial exposure is moderate, and so I believe this is a good time and place to consider this name.

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ITT Overlooked And Undervalued As A Late-Cycle Play

Emerson Stumbles Again On Margins, But The Long-Cycle Story Still Has Appeal

When I last wrote about Emerson (EMR), I tempered some of the undervaluation I thought I saw with the comment that, “… I have some concerns that the shares could underperform as investors look for more exciting stories.” Prior to a recent sell-off, Emerson shares had more or less been drifting around the sector averages, but lagged the likes of Ingersoll-Rand (IR), Honeywell (HON), and Yokogawa (OTCPK:YOKEY). Actual results did show further slowing in the business, but this looks more like a pause than a real shift.

I do think process automation order momentum has probably peaked, but there’s a rich project funnel to deliver on over the next few years, and I think Emerson has meaningfully improved its process automation operations after the Pentair (PNR) deal. Further progress in discrete and hybrid markets would be gravy on top of that. I do have some concerns about the Climate business, but not enough to cancel out what looks like a relatively undervalued opportunity in an expensive industrial sector.

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Emerson Stumbles Again On Margins, But The Long-Cycle Story Still Has Appeal

Eaton Keeping Its Ducks In A Row And Still Undervalued

In the context of my general view of "long-cycle good, short-cycle bad", Eaton's (ETN) performance was largely as I expected in the first quarter. The stock performance also continues to support my general idea that Eaton, along with Honeywell (HON) is a better-than-average choice right now, as the shares have outperformed its industrial peers since the fourth quarter report (though not keeping pace with Honeywell!).

I still have my worries about shorter-cycle industrial markets, but I think Eaton's broad exposure to a wide range of end markets across a wide range of geographies helps insulate it somewhat, and I think the company is well-placed to benefit from growth opportunities in areas like data centers, aerospace, and perhaps some renewed vigor in oil & gas. The shares aren't dramatically cheap but still offer relatively decent upside in a sector where a lot of names have gotten pricey and where expectations have gotten more and more demanding.

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Eaton Keeping Its Ducks In A Row And Still Undervalued

Startlingly Good Results From Atlas Copco Support The Quality Premium Argument

Atlas Copco (OTCPK:ATLKY) won’t have the best quarter among multi-industrials this quarter, Honeywell (HON) and Dover (DOV) already surpassed them in organic growth, but the level of outperformance was startingly high all the same and further supports the argument for Atlas Copco as a best-of-breed multi-industrial. Although there are signs of deterioration if you look for them, management seemed relatively unconcerned about the health of the business.

Atlas Copco ADRs have shot up about 20% since my last update (the local shares have done better), when I said that the shares looked about as promising as they get on valuation. It’s a lot harder to reiterate that argument now, and I’d rather wait for a pullback than chase these shares in what I still believe will prove to be a decelerating macro backdrop.

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Startlingly Good Results From Atlas Copco Support The Quality Premium Argument

Rockwell Skids On A Weaker Auto End-Market

The last three months haven’t been particularly kind to Rockwell (ROK), as the share price of what is usually a darling among industrials has lagged the broader industrial sector, and automation peers like Yaskawa (OTCPK:YASKY), Fanuc (OTCPK:FANUY), Nidec (OTCPK:NJDCY), Emerson (EMR), Schneider (OTCPK:SBGSY), and even ABB (ABB). To be fair, it was the significant slide after second quarter earnings on Thursday that did the damage, though the shares had still been lagging most automation companies (except ABB) and were only slightly better than the average industrial before the report.

Like 3M (MMM), Sandvik (OTCPK:SDVKY), SKF (OTCPK:SKFRY), Illinois Tool Works (ITW), and the Japanese automation companies, weakness in autos is a major contributor to Rockwell’s present weakness, but I took management’s guidance and comments as reflective of some potential warnings about spreading weakness in other industrial end-markets – something that I’ve been expecting as this year rolls on. Rockwell shares are now in a tough situation valuation-wise; they’re not so clearly undervalued that I’m inclined to say “just buy and wait for the cycle to reverse), but the valuation is getting more reasonable and this is a stock to watch more carefully now.

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Rockwell Skids On A Weaker Auto End-Market

3M Decimated On Autos, Electronics, And Execution

Thursday’s first quarter earnings report was the worst day for 3M (MMM) shareholders in a long, long time, as a huge double-digit miss at the segment profit line drove a double-digit decline in the share price. While 3M is not going to burn down, fall over, and sink into the swamp, the shares are going to be in the penalty box for a while, and management needs to prove convincingly that they can not only improve margin execution, but restructure the business in the direction of both great margins/returns and at least decent growth.

3M’s valuation is much more reasonable than it has been in some time, but it’s fair to ask and wonder if turning around this supertanker is going to be a longer process. If the problems really are confined primarily to auto and electronics, this is a name to investigate further, but I don’t think investors need to make a snap decision for fear of missing out, as the concerns about 3M’s growth and execution capabilities have been building for a while and won’t go away in quarter.

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3M Decimated On Autos, Electronics, And Execution

Few Sour Notes For Honeywell

At the risk of drifting into the territory of a broken record, Honeywell’s (HON) performance continues to back up my view of the company as one of the best multi-industrials today. With Honeywell’s longer-cycle businesses hitting the sweet spots of their cycles, the company’s growth is finding another gear at a time when shorter-cycle results are likely to be choppier.

With its core businesses doing well (and with runways to do even better) and ample capacity to do more M&A, but no particular necessity, the only issue I have with Honeywell is, predictably enough, the price. It’s tough for me to push my valuation models beyond a fair value of $170 today, and I think Honeywell is now enjoying the status as a Wall Street darling and growth safe haven. Honeywell has earned this love and I wouldn’t advise stepping in front of this freight train, but it’s tougher to get excited about the returns on offer from this high level.

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Few Sour Notes For Honeywell

ABB Balancing The Reality Of Familiar Problems And New Leadership Opportunities

ABB (ABB) continues to be a relatively underwhelming, if not disappointing, player in the multi-industrial space, as the company largely missed out on the recent up-cycle due to various execution issues. While process automation and electrification are still performing relatively well, a global slowdown in discrete manufacturing and automation is creating some near-term challenges, and there is a lot left to do in M&A integration and margin improvement.

The announcement of the departure of the CEO could improve the tone somewhat, but this change is not coming from a place of strength and it is going to take time for the next CEO to make meaningful positive impacts – assuming the board lets that happen. While I do still see avenues for ABB to do better, the upside I see is certainly “at risk” and I don’t regard this as a core holding at this point.

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ABB Balancing The Reality Of Familiar Problems And New Leadership Opportunities

ABB Still Has A Lot To Do And A Lot To Prove

Owning ABB (ABB) has not been a particularly rewarding experience. While the company's decision to sell its Power Grids business to Hitachi is a sound one, and the company has attractive opportunities across its business units, a long history of underperformance relative to the opportunities available is not something investors should just ignore.

Valuation, and the idea that ABB can be/do better than this, remain the best arguments for sticking with the stock, but that's an increasingly unconvincing argument to me, and I can't really say that you should favor ABB over Eaton (ETN), Schneider (OTCPK:SBGSY), and Honeywell (HON), let alone a long list of other industrial names.

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ABB Still Has A Lot To Do And A Lot To Prove

Emerson Not Expensive, But Slowing Growth Is A Concern

Emerson Electric (EMR) hasn’t been left behind in the recent industrials rally, but it also hasn’t really distinguished itself as an outperformer, as it seems that the Street is concerned about the risks of slowing non-residential spending (particularly in China) and weaker process automation spending in the face of weaker oil prices. My concerns have more to do with the fickleness and short attention spans of institutional investors; Emerson has most likely passed through its point of peak growth, and I have some concerns that the shares could underperform as investors look for more exciting stories.

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Emerson Not Expensive, But Slowing Growth Is A Concern

Eaton Hitting Its Marks, But Still A Controversial Name

This fourth quarter earnings and guidance season has gone a little better than expected, with many companies having fine-tuned their guidance before the end of 2018 and defanging some of the potential disappointment here in January and February. Even so, there is still a lot of uncertainty regarding the health of the U.S. and global economies, with multiple multi-industrials (including Honeywell (HON), Illinois Tool Works (ITW), and 3M (MMM) ) establishing some rather low numbers for the low end of their 2019 growth outlooks.

I continue to like Eaton (ETN), even if more on a relative, “it’s not that bad” basis. I am definitely concerned about the risk of slowing demand in “general industrial”, trucks, off-road machinery, and non-residential construction, but management’s guidance for the year was fairly encouraging and markets like aerospace and data center are still looking healthy. With skepticism already seemingly built into the valuation, Eaton is a name that could surprise if 2019 proves to be better than expected for the U.S. and global economies.

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Eaton Hitting Its Marks, But Still A Controversial Name