Honeywell International (HON 0.22%) reported earnings last week that came in above expectations, but the stock sold off by about 6% over the next two days. It is now down year to date despite a monster 2023 for the overall market.
On the surface, nothing seems to be too wrong with Honeywell's business. It took a while, but the company has finally rebounded from the pandemic and has returned to growth. But the diversified industrial conglomerate remains laser-focused on improving its operating margin, almost to a fault.
Let's dive into the pros and cons of Honeywell's strategy to see if the Dow stock is headed in the right direction or if there is danger lurking ahead.
Image source: Getty Images.
A primer on Honeywell's strategy
The company operates four major segments -- aerospace, Honeywell building technologies (HBT), performance materials and technologies (PMT), and safety and productivity solutions (SPS). The objective is for each segment to be efficient and profitable on its own, which in turn will help drive overall high operating margins. This strategy also ensures the company is diversified enough to absorb a slowdown in key end markets, something that a pure-play company can't do as well.
Honeywell's long-term targets call for 4% to 7% organic growth, 40% gross margins, 25% segment margins, and a free cash flow (FCF) margin in the mid-teens. This game plan resembles more of a consumer staples company like Procter & Gamble (PG -0.78%) than an industrial company that tends to favor a better growth rate.
For the last few years, Honeywell has operated at a low- to mid-single-digit growth rate. However, this wasn't always the case, as Honeywell enjoyed a rapid growth rate in the years after the Great Recession of 2008 until about the height of the U.S.-China trade war in 2018.
The pros
A low-growth, high-margin strategy has its benefits. High FCF margins should help drive dividend growth and support healthy share buybacks.
Similarly, slow and steady growth and high profits are great for financial health, such as keeping debt off the balance sheet.
Having a strong balance sheet, a stable and growing dividend, and a sizable share-buyback program is what risk-averse, income-focused investors love. But it's not that appealing to those who want to see a company take risks that can potentially open the door to new revenue streams.
The cons
The problem with obsessing over high margins is that it can lead a company to miss out on key investments that could unlock sizable returns over time. Back to our consumer staples example: There's only so much organic growth and innovation a company like Procter & Gamble can achieve. Most of its earnings growth comes from price increases and the development of the overall economy.
But Honeywell has a lot of opportunities that are there for the taking. In fact, the company itself has identified and is investing in many of these opportunities.
The opportunity is there, but HON isn't pursuing it aggressively
Honeywell has spent years talking about the Industrial Internet of Things (IIoT), which involves marrying the digital world with the physical world by incorporating sensors and software into product offerings. In turn, this helps customers visualize asset performance, identify maintenance problems and cybersecurity threats before they occur, and more.
There are plenty of examples of IIoT across the company's business. The Honeywell smart buildings segment uses a variety of technologies for better security, temperature, and lighting control; energy use; air filtration, and more. This is a good example of how it is connecting what used to be stand-alone products like thermostats and air purifiers into an integrated system.
Another example is Honeywell smart energy, which connects gas, water, and electric utility systems that make for a smart and safer energy grid.
Lastly, Honeywell has developed a variety of software-as-a-service solutions that provide recurring revenue, such as Honeywell forge.
The point here is that it has a big opportunity. Heightened allocation of resources toward these growth avenues could benefit Honeywell in the long run at the expense of profit margins in the short term. At the very least, the company's balance sheet is strong enough to handle a large acquisition if management prefers to harness inorganic growth instead.
However, for as much as management touts the massive opportunity in this area, spending on these endeavors appears subdued. Honeywell's capital expenditures to revenue -- a metric of spending intensity -- is at levels we saw during the depths of the pandemic and the Great Recession.
HON CAPEX To Revenue (TTM) data by YCharts
Honeywell has chosen its path
Honeywell boasted about its results on its earnings call. But there were a number of analyst questions that seemed to indicate Wall Street wants it to go in a different direction.
When asked on its most recent conference call about the trade offs between margins and growth, newly appointed CEO Vimal Kapur said that he is satisfied with organic growth of 4% to 7% and that it will look at mergers and acquisitions as a way to unlock further growth.
What comes next
Former CEO Darius Adamczyk, who led the company from 2017 to 2023, stepped down in June. There were questions about what direction Honeywell would go after his departure. The recent earnings call makes it abundantly clear where Kapur plans on taking the company, which is in a conservative direction.
A few years ago, Honeywell stood out as an industrial company that was aggressively targeting exciting new trends in IIoT, automation, and artificial intelligence. Now, the company seems more like it is going through the motions and is unwilling to put meaningful growth capital to work, unlike other industrial companies.
It could be that Kapur is still settling into his new role as CEO and may take the company in a different direction in the future. Strategies can change on a dime. And if Kapur and his team realize there's a better path toward driving shareholder value than marginal growth, dividends, and buybacks, then it wouldn't be surprising if Honeywell takes a more aggressive approach.
In the meantime, Honeywell's margin-focused strategy has many benefits that shouldn't go unnoticed. But ignoring the drawbacks of this strategy, and what management is effectively leaving on the table, would be a big mistake.
