Investors often focus on earnings, but a strong balance sheet helps to ensure companies can and will get earnings growth. Here are two real-life examples from General Electric (GE 1.09%) and Honeywell International (HON -0.09%) that help to explain why manageable debt and good working capital management matter so much.
It's no secret that GE's debt grew under former CEO Jeff Immelt as he pursued a strategy of investing for growth. He invested heavily in a slew of oil and gas businesses only to walk into the slump in the price of oil in 2014. In addition, the once highly profitable power business (mainly coal and gas-fired turbines) suffered a dramatic fall in end demand in 2018 due to the rise of renewable energy. It came only a few years after Immelt's $10.9 billion acquisition of Alstom's power assets.
While Immelt made acquisitions, GE's industrial debt grew while its earnings were getting weaker. Investors and rating agencies usually measure debt in terms of a multiple of earnings, for example the net debt to earnings before interest, taxation, depreciation, and amortization (EBITDA). Generally speaking a net debt to EBITDA multiple of 2.5 times EBITDA or less is seen as favorable for investment grade debt for an industrial company.
Unfortunately, by 2018 GE's situation was so bad that management expected a multiple of 3.5 times EBITDA in 2018 (for its industrial debt & EBITDA) and was left scrambling to try and reduce it to less than 2 times EBITDA by 2020.
In contrast, Honeywell's net debt to EBITDA multiple has been never been above 1 times EBITDA over the last decade.
In order to carry on reducing its net debt to EBITDA multiple, GE was under a lot of pressure to reduce debt as its earnings continued to disappoint. Consequently, GE sold its biopharma business to current CEO Larry Culp's former company, Danaher. It looked like a good deal for Danaher then and seems an even better one now. Not only did the COVID-19 pandemic lead to heavy investment in related vaccines and therapies, but it also enhanced the long-term growth potential of the business Danaher bought from GE.
If Immelt had been more disciplined regarding GE's balance sheet, maybe GE wouldn't have sold the biopharma business? It's hard to know the answer to that question, but it's easy to know GE's management would have had more flexibility if the company hadn't had so much debt on its hands. So it's a lesson about maintaining a good balance sheet.
A high debt-to-EBITDA ratio implies a company is funding its business through debt rather than earnings, and a low ratio means the reverse. In Honeywell's case, its debt has long been manageable. If you add cash into the equation, its net debt is forecast to be just $9.4 billion at the end of 2022.
The solidity of Honeywell's balance sheet has enabled the company to invest in growth initiatives, not least its ongoing development of Honeywell Forge, Honeywell's mix of software products that allow customers to use digital data to improve the performance of their industrial assets. It's worth noting that one of the reasons GE's Immelt made the oil and gas and power acquisitions was precisely to add GE's Industrial Internet of Things capability to the acquired businesses and add value. However, Honeywell is executing its plans better partly due to having a stronger balance sheet.
In addition, Honeywell has a host of so-called "breakthrough initiatives" from which it expects to generate strong sales growth. They include its majority investment in a quantum computing business, Quantinuum, and sustainable technology solutions (renewable fuels, clean hydrogen, carbon capture, energy storage, plastics recycling, sustainable refrigerants). Honeywell's Unmanned Aerial Systems (UAS) and Honeywell Urban Aerial Mobility (UAM) business segments are developing avionics and propulsion systems for air taxis and cargo drones.
While it's fair to say that Honeywell has had more favorable end markets in the last decade, a large part of the reason for the company overtaking GE's market cap comes down to its greater discipline over its balance sheet and allocating capital to those high-potential markets. A good balance sheet matters.
In both of these examples, the companies with good balance sheets have the flexibility to invest well, while it's fair to say GE might not have sold its biopharma business if it had a stronger balance sheet. Moreover, with the market's decline in 2022 creating some buying opportunities (in both listed and private companies) it's Honeywell that's better positioned to take advantage of it.