2 Green Flags and 1 Red Flag for Honeywell After Its Post-Earnings Sell-Off

Honeywell International (HON 0.22%) stock sold off after reporting earnings last week. But despite being down on the year, the stock is still within striking distance of an all-time high after a rip-roaring performance in 2022.

Let's dive into the state of Honeywell's business to determine if the diversified industrial stock is worth buying now.

Image source: Getty Images.

Honeywell Aerospace is back

Honeywell's Aerospace segment is its largest by sales and profit. But it was the hardest hit during the COVID-19 pandemic. And for good reason.

The business is heavily dependent on the commercial airline industry. But it also provides navigation systems, actuation systems, and a variety of other small and large solutions for naval and commercial ground transportation, helicopters, the defense industry, the oil and gas industry, and more. Simply put, if there's a vessel that demands mechanical and electric work, Honeywell is probably involved in some capacity.

Honeywell's market position makes it heavily dependent on the strength of the broader economy, but more specifically, global commerce and the transportation of goods as well as people traveling for work or leisure. Honeywell's second-quarter 2023 results indicate that the aerospace segment is officially back.

Data source: Honeywell. 

In the above table, you can see the gravity of the hit Honeywell Aerospace took in Q2 2020. Fast forward to today, and the segment is generating about 95% as much revenue as it was in Q2 2019, but the profit and profit margins are actually higher -- a sign that Honeywell is on track to return to growth.

On track to hit its long-term goals

Honeywell's long-term strategy is centered around margin growth and operating a more efficient, leaner business.

Data source: Honeywell. 

The above table gives an idea of Honeywell's slow growth over the last decade. Like many diversified industrials, Honeywell became clunky in years past and struggled to achieve meaningful organic growth, often having to resort to acquisitions. However, the company's 2023 guidance puts it close to its long-term targets. And some segments, like Aerospace and Honeywell Building Technologies, have already achieved segment margins above 25%. 

High margins, but at what cost?

The following chart puts into perspective where Honeywell's business is headed and where it is coming from.

HON Revenue (TTM) data by YCharts.

Honeywell's revenue is about the same today as it was 15 years ago -- which isn't exactly a good look. However, its operating margin sits at just under 20%. A 20% operating margin is excellent, especially for a company with so many moving parts like Honeywell. It means that the company is taking home 20 cents in operating income for every dollar in revenue. So, although revenue hasn't changed much in 15 years, the company's operating margin is up more than threefold.

Operating income and growing earnings are far more important than revenue. It isn't too hard for Honeywell to simply crank out more products and discount them to boost sales. The real trick comes from getting more profit out of each dollar in sales and then gradually increasing sales in lockstep with a stable operating margin. This is something that companies like Illinois Tool Works, an industrial conglomerate, have mastered to perfection.

If a growing operating margin is a good thing, then why is this a red flag? It's not the results and margins themselves that are bad. Rather, it's how those results impact Honeywell's valuation.

Despite its lackluster top-line growth, Honeywell stock has had an incredible run. In the last 10 years, it is up 140% compared to diluted EPS, growing at 109% and operating income, growing by just 57%.

Honeywell's price-to-earnings (P/E) ratio sits at 24.2 compared to a 10-year medium of 20.5. It's not terribly expensive, but it's also not cheap, especially for a company that is content with an organic growth rate of just 4% to 7%.

Companies that feature impressive top and bottom-line growth can benefit from a rising P/E ratio, meaning the stock price grows at a faster rate than earnings -- which is exactly what has happened to companies like Apple. But Since Honeywell's growth rate is so low, it's unlikely to benefit from a valuation multiple expansion. For Honeywell's P/E ratio to stay the same, it has to grow earnings at the same rate as its stock price. So if Honeywell grows earnings by 5% a year, expect a 5% increase in the stock price just to keep the same P/E ratio. However, there's also room for that P/E ratio to compress.

Honeywell stock is a decent, but not great buy

Honeywell stock doesn't deserve to be at an all-time high and is unlikely to be a market-beating stock in the near-term future. The rebound in its business and margins are impressive. But with a low growth rate and just a 2% dividend yield, the stock isn't necessarily a screaming buy now.

Honeywell is an established, conservative business with an excellent balance sheet. It's still a great option for risk-averse investors focused more on capital preservation rather than capital appreciation. But for investors with a higher risk tolerance that are still in the capital appreciation phase of their lives, Honeywell needs to improve its growth rate, or the stock needs to reach a more attractive valuation for it to be a compelling buy.