Despite Coronavirus Challenges, Honeywell Is Still a Buy

Just a few short months ago, Honeywell (HON 0.43%) looked in good shape for 2020. Exposure to aerospace gave it favor with the market, and there were hopes for a solid year of low-single-digit organic revenue growth. Unfortunately, the COVID-19 pandemic has thrown those assumptions out the window.That said, let's take a look at what investors can expect from the company and the stock.

What kind of recovery

The growing consensus is for the second quarter to mark the bottom of the industrial economy and an improving trend to develop from there. Indeed, Honeywell CFO Greg Lewis joined the choir during the May 1 earnings call, saying, "GDP Q2 will be the worst, improve in Q3, and improve in Q4. So obviously, our margins will kind of follow that trend."

So, if you are looking for the earnings trough on a rolling-year basis, then it's probably going to occur in the first quarter of 2021. After which, Honeywell should start to grow rolling-year earnings again.

The key question is what kind of long-term growth prospects does the company have?

Image source: Getty Images.

How Honeywell makes money

It's useful to break out Honeywell's earnings into segments. As you can see in the chart below, aerospace is Honeywell's largest earnings generator, but it doesn't provide a majority of earnings, and recall that around 40% of Honeywell's aerospace business comes from defense and space markets. More on aerospace later. 

Data source: Honeywell presentations.

In the near term, all the segments are going to take a hit, with management forecasting its second-quarter sales to decline by more than 15%. However, as noted above, a recovery should start in the third quarter provided governments start to relax COVID-19 containment measures.

Data source: Honeywell presentations.

Honeywell's growth post COVID-19

Honeywell reports its sales growth in nine business subgroups, and it's useful to look at which areas might be challenged.

The strong businesses are obviously defense and space (aerospace segment) and also productivity solutions (SPS segment). Defense is not a cyclical activity and Honeywell's productivity solutions contain a warehouse automation business, Intelligrated, which will arguably be a net beneficiary in a post-COVID-19 world. Intelligrated primarily provides machinery for e-commerce logistics. These two business contribute around a quarter of total sales.

Another set of business are likely to grow in line with the economy. HBT probably belongs in this group. CEO Darius Adamczyk sees a growth opportunity because HBT's building management systems and controls help make commercial buildings safer and healthier, but a slowdown in commercial construction will obviously pressure spending. Advanced materials sales (PMT segment) will probably grow in line with long-term growth in construction and automotive activity, while safety products is likely to see good growth in personal protective equipment offset by some weakness in fall protection equipment.

Data source: Honeywell presentations and author's calculations. UOP sells to refiners.

The challenged business

There's no way to sugarcoat the fact that the COVID-19 pandemic has significantly challenged the outlook for Honeywell's aerospace aftermarket and original equipment manufacturer (OEM) businesses, and it's very hard to see anything other than a slow recovery from a much lower base. As such, its aerospace business could grow in line with the economy rather than the mid-single-digit range it's seen in in recent years. 

However, it's far from clear what the shape of the commercial aviation recovery will be. It's not just a matter of the public's willingness to fly, there's also the question of government restrictions on travel and the financial condition of the airline industry.

Data source: Honeywell presentations, YOY=year-over-year.

Meanwhile, the crash in the price of oil has caused issues for Honeywell's UOP, a business selling catalysts and absorbents to refiners, and also at process solutions -- both PMT businesses. Process solutions work with the management of the flow of fluid materials such as in the chemicals and refining industry.   On this subject, Lewis noted during the earnings call, "oil price volatility and sustained pressure on prices often lead to project delays and customer capex and opex budget cuts, which is what we are seeing today."

However, theoretically at least, low oil prices shouldn't cause a long-term problem for Honeywell. After all, they could actually encourage more refining and processing (good for PMT), and the company has very little exposure to upstream oil & gas spending -- around 5% of PMT sales.

Together, the challenged businesses contribute around 45% of Honeywell's sales.

What it means to investors

Honeywell is currently trading at 17.36 times forward earnings projections. Meanwhile, its mix of businesses suggest the downside scenario is low-single-digit revenue growth over the medium term. However, if aviation comes back strongly and the price of oil stabilizes, then Honeywell could easily turn into a mid-single-digit grower.

On balance, Honeywell is a decent value for the first scenario, and a good value for the second. An attractive investment proposition.