5 Things the Market Missed From Honeywell's Earnings

The third-quarter earnings from Honeywell International (HON 0.22%) were always going to be complicated by the spinoff of turbocharger company Garrett Motion (GTX -0.51%) and the forthcoming spinoff of home-products company Resideo. However, upon closer inspection, it was a very positive quarter for Honeywell, with one key twist -- potential pressure on margin in 2019 from tariffs.

Let's take a closer look at key takeaways from the earnings, and see how the company is placed for 2019.

1. Honeywell's earnings...and earnings

In a nutshell, Honeywell beat its own earnings expectations in the third quarter and raised its underlying guidance for the full year. It's important to distinguish between underlying and actual guidance, because in reality Honeywell will lose some earnings from Garrett and Resideo.

A recovering business-jet market is helping Honeywell's aerospace sales. Image source: Getty Images.

Specifically, the actual guidance already excludes Garrett -- that business has already been spun off -- and two months from Resideo. Management estimates that the net impact from the spinoffs will be $0.31. As you can see in the table below, the guidance for pre-spinoff earnings per share (EPS) was actually increased to between $8.22 and $8.27, from a range of $8.05 to $8.15 given on the second-quarter earnings call in July:

Data source: Honeywell International presentations. *Does not include impact of Garrett and Resideo spinoffs.

The key takeaway is not to worry too much about the reduction in actual guidance. Indeed, as CFO Greg Lewis noted, Honeywell's EPS guidance "equates to growth of 16% to 17% for the full year, removing the segment profit contributions from the spins in both periods."

Moving onto the fourth-quarter guidance, Lewis said that "removing the after-tax segment profit contributions from the spin[off]s in both periods, fourth-quarter EPS, adjusted, is expected to be 17% to 20% up."

The spinoffs may well reduce reported profit growth, but Honeywell is on a strong growth trend with its remaining businesses.

2. What the loss of Resideo and Garrett Motion means for Honeywell

Whenever a company spins off some businesses, there's always a degree of concern regarding what losing them will mean to the remaining company's operating metrics. As we have already seen, there will be an impact on earnings, but what about cash flow and margin?

As you can see below, the loss of businesses hasn't resulted in any reduction in organic sales growth guidance, segment margin, or free cash flow generation. In fact, all these guidance metrics have improved:

Data source: Honeywell International presentations.

3. Aerospace is firing on all cylinders

The main reason for Honeywell consistently raising guidance this year has been the excellent performance of aerospace, with 42% of segment profit year to date, and safety and productivity solutions (SPS), with 12%. The good news is that all the aerospace segment's sales by end market are entering 2019 in growth mode:

Data source: Honeywell International presentations. Chart by author.

Moreover, CEO Darius Adamczyk, a man not known for hyperbole, declared himself "bullish" on the aerospace segment. He said during the earnings call that "all three of these tracks that we always talk about, which [are] the commercial, the business jet, and defense, are all pointing either strongly up or up; 2019 looks very promising based on what we're seeing today."

4. Warehouse automation is a high-growth area in which to invest

The other area of particular strength for Honeywell entering 2019 is the P (productivity) bit of SPS -- the exciting part coming from its warehouse automation sales. It's a market driven by growth in e-fulfillment and logistics, and Amazon.com is a longtime Honeywell customer.

Data source: Honeywell International presentations. Chart by author.

Following the success of the Intelligrated acquisition, Honeywell recently acquired Europe-focused warehouse automation business Transnom for 425 million euros. Transnom has sales of 100 million euros and is currently growing at 30%; it will enable Honeywell to grow in Europe, including with U.S. companies that have operations there.

5. Margin pressure from tariffs

On a less positive note, when discussing the preliminary outlook for 2019, Lewis noted the "pressure on margin rate expansion" coming from the imposition of trade tariffs. The actions taken in 2018 resulted in a "minimal and manageable" impact, but he now anticipates "the impact to 2019, prior to mitigation actions, will be significant," and said Honeywell is planning for the worst.

This is obviously a concern, but investors will have to wait and see how events pan out in the coming year.

How investors should view Honeywell's earnings

There are more positives than negatives. Honeywell delivered a strong set of earnings and a guidance raise. Meanwhile, the losses of Garrett and Resideo don't look like they'll significantly affect margin or FCF, and the remaining businesses, particularly aerospace and SPS, look well-placed for growth in 2019.

On the downside, management has told investors about potential pressure on margin due to tariffs. And the loss of some $0.90 in EPS from Garrett and Resideo in 2019 will make EPS growth superficially weaker than it really is.

However, with analyst consensus for EPS of $8.43 in 2019, and management guiding toward 100% FCF conversion from income, Honeywell trades at a forward price-to-FCF multiple of 18. That's a good value for a stock growing underlying earnings in the double digits.