It hasn't been a great year for investors in General Electric (GE -1.75%) or Honeywell International (HON 0.38%). The COVID-19 pandemic and the associated travel bans have caused a severe slump in the commercial aviation sector and that's bad news for businesses that have commercial aviation as their biggest single profit generator.
But investing in stocks is more about what will happen in the future, so let's take a look at which one of these industrial giants might be a better value right now.
General Electric and Honeywell valuations
Industrial conglomerates are traditionally valued on the basis of an earnings or free cash flow (FCF) multiple. The idea is that they should be diversified enough to generate earnings/FCF throughout an economic cycle, give or take some adjustment for the state of the economy. As a rough benchmark, a figure of 20 times FCF is probably a fair value for an industrial conglomerate. FCF is simply what's left over from operating cash after capital spending.
Image source: Getty Images.
To put this into context, an FCF of 20 implies the company is generating 5% of its market cap in FCF. Theoretically, that FCF can be used to pay a dividend, make stock buybacks, or help fund acquisitions to boost growth. A quick look at GE and Honeywell on a trailing-price-to-FCF basis makes the decision look like a no-brainer (see chart below).
Moreover, the slump in the economy in 2020 means that GE's management believes its FCF will be negative for the full-year, while analysts have Honeywell generating around $4.7 billion, putting it on a 2020 price-to-FCF multiple of 21.1 times. Again, Honeywell looks like the clear winner.
Data by YCharts
Long-term value for GE
GE bulls will argue three points:
- The company is in the middle of a multi-year turnaround (particularly in its power and renewable energy segments), so its current FCF isn't reflective of its long-term potential.
- Commercial aviation (more important to GE than it is to Honeywell) has obviously taken a major hit in 2020, so this year's FCF projection is also not representing the long-term potential.
- The nature of GE Aviation (around three-quarters of revenue comes from commercial engines and services) means that one-year-out FCF is not the best way to measure the business.
To add some color to the third point, consider that aircraft engines tend to be sold at a loss in order to generate lucrative aftermarket and service revenue a few years after they start to need to be serviced.
To build these points into a comparison, let's take a look at a snapshot of what the investment proposition for GE could look like in 2022. By then the power and renewable energy segments should be cash generative and in growth mode, and aviation should have recovered. Based on analyst FCF estimates, and the current market cap, GE will trade at 18 times FCF in 2022.
|
General Electric |
2019 Free Cash Flow |
2022 and Beyond |
|---|---|---|
|
Power |
($1.5 billion) |
GE Power will get back to high-single-digit earnings/FCF margin with $1 billion in FCF and low-single-digit growth in the future |
|
Aviation |
$4.4 billion |
GE Aviation will recover in line with commercial aviation recovery, and long-term FCF will be generated from engine spares sales |
|
Renewable energy |
($1 billion) |
Margins will get back on track for high-single-digits in line with peers, and the bet on offshore energy will start to pay off |
|
Healthcare* |
$1.2 billion |
Steady low- to mid-single-digit growth in earnings/FCF |
|
Corporate & eliminations |
($2.1 billion) |
Cost cuts will lower outflows |
|
Total GE industrial* |
$1 billion |
Analyst projections for $3.5 billion |
Data source: GE presentations, marketscreener.com, author's analysis. *Excludes $1.3 billion from the biopharma business
Long-term value for Honeywell
In comparison, analysts are expecting Honeywell to be generating $6.1 billion in FCF in 2022, a figure slightly above that generated in 2019. It would put Honeywell on 16.6 times FCF in 2022, a figure notably lower than that projected for GE.
In addition, Honeywell has a far more diversified set of income streams than GE does. To illustrate this point, here's a look at Honeywell's segments by share of revenue in 2019. As you can see below, Honeywell actually generates nearly double the revenue from its defense and space segment compared to its commercial aviation original equipment market (OEM) -- the aftermarket is seen as recovering faster than OEM in aerospace.
Data source: Honeywell presentations. UOP sells catalysts and absorbents to refining companies.
Honeywell certainly has businesses that are cyclically challenged in the near term -- overall sales are expected to decline more than 15% in the second quarter of 2020. However, it also has some strong long-term growth businesses such as warehouse automation (productivity solutions), defense, and space.
In addition, the company's process solutions, UOP (which sells catalysts and absorbents to refining companies), and advanced materials segments should recover in line with the economy. In addition, there's even an argument that building technologies segment sales will receive a boost in a post-COVID-19 world as building owners seek to create healthier buildings.
Honeywell or General Electric?
On a risk/reward basis, there are two reasons why Honeywell is the better buy. First, on current, 2020, and 2020 projections, it trades on a lower FCF multiple than GE. Second, there's probably less risk in Honeywell meeting analyst expectations than there is with GE right now.
You can build a case for GE, but it relies on a multi-year turnaround in power and renewable energy -- including the success of its nascent offshore wind business -- and an ongoing recovery in commercial aviation.
Simply put, there are a lot more things that need to go right for GE than there are for Honeywell, and the latter's valuation is more compelling anyway. Honeywell is the better buy.
