Is Honeywell Becoming the New 3M?

Two diversified industrial giants; two companies whose sales growth has stuttered in recent years; two that underwent piecemeal reorganization that left investors unimpressed; and two stocks that are both down this year. Honeywell (HON 0.22%) and 3M (MMM 0.46%) have some things in common, but will that similarity lead Honeywell to the kind of dismal stock performance (down 55% in five years) 3M investors suffered recently? Here's the lowdown. 

Honeywell and 3M

The best way to answer the question is with three "nays" and one "maybe." The first nay comes from looking at each company's earnings growth prospects. To be clear, I'm not talking about the legal issues 3M has had in recent years. They have undoubtedly hurt the stock price, but what's sometimes forgotten is its disappointing operational performance. 

There are two things to focus on here. The first is profit margin progression, and the second is revenue growth. A quick look at each company's profit margins over the last decade shows contrasting performance. Honeywell's gross profit margin (a good indicator of how much pricing power a company has) is rising, while 3M's is in decline. It's the same story with operating profit margin, implying that Honeywell can grow profits even on flat revenue. 

HON Gross Profit Margin (Annual) data by YCharts

Zeroing in on revenue performance, the following chart shows how Honeywell's organic revenue growth has tended to be better than 3M's. The big difference in 2020 comes from the fact that 3M saw a surge in demand for respirators while Honeywell's aerospace operations (and other cyclical businesses) suffered from the pandemic outbreak.

Data source: Company presentations. *Represents the midpoint of Honeywell's guidance and 3M management's guidance toward the low end of its original flat to negative 3% full-year growth guidance. 

The two companies also diverge in terms of meeting management's guidance. As previously discussed, Honeywell has an excellent track record of beating its guidance, having raised full-year earnings guidance on earnings calls since the start of 2021. Meanwhile, 3M's track record is poor and attracted the ire of one of its leading shareholders earlier in the year.

Honeywell's valuation was already rich

The second "nay" comes from the argument that Honeywell's stock underperformance this year isn't so much a vote on its operational performance as it is a valuation correction. Focusing on enterprise value (market cap plus net debt) to earnings before interest, taxation, depreciation, and amortization (EBITDA), it's clear that Honeywell has been richly valued for some time, while investors are hesitant to buy 3M even on its lowly valuation. 

HON EV to EBITDA data by YCharts

Honeywell realigns from a stronger position

The final "nay" comes from the recent Honeywell realignment, which recalled how 3M realigned its business from five operating segments to four in 2019. The realignment made it easier for 3M to spin off its healthcare business -- something it will complete in due course. That event came to mind recently when Honeywell announced it would realign its segments. As you can see below, the change is piecemeal at best. There's a name change, and Honeywell Process Solutions has been moved away from its former grouping. 

Data source: Honeywell presentations. 

However, the change reflects the opportunity Honeywell's management has to unlock value. Aerospace, industrial automation, and sustainable technologies are all sectors that tend to command healthy valuations. While management may stay wedded to maintaining its conglomerate structure, there's little doubt investors will start pushing for a breakup if it becomes clear these businesses would be better valued as separate companies. 

The difference is Honeywell is doing it from a position of strength. At the same time, 3M's healthcare business is a weak spot for the company despite substantive mergers and acquisitions activity. 

Honeywell, the new 3M?

The one aspect where Honeywell could follow 3M is if Honeywell's management doesn't grasp the opportunity to unlock the potential in its portfolio of businesses by being more aggressive with its restructuring. In 3M's case, its restructuring appears reactive, while Honeywell needs to get ahead of events and deploy its financial firepower to buy growth businesses. 

Honeywell's management recently talked of a robust pipeline of deals within the $1 billion to $7 billion range -- something investors will be eager to see from the company in due course because it has the firepower to boost its growth through the right acquisitions.