As an investor, it can be challenging to discern when a stock price moves for valuation concerns versus material changes in a business's trajectory. That's a consideration when looking at Honeywell International (HON -0.01%), whose stock is down 13% year to date and 22% from its all-time high.I'd argue that there's nothing fundamentally wrong with the company, and the decline is more of a valuation correction, rather a vote on the progress of the company through the year. Does that make the stock a buy now?
Honeywell in 2023
The company is an industrial conglomerate, and it's doing what one should do. In other words, it has a mix of businesses with various end markets that allow the company to grow across multiple market conditions. That much can be seen in Honeywell's third-quarter sales performance, where strength in aerospace and a solid showing from its performance materials and technologies (PMT) business offset weakness elsewhere.
If you are wondering, the third quarter organic sales growth of 2% doesn't quite reflect the quantum of growth in 2023. For example, management expects full-year organic sales growth of 4% to 5%, with 3% to 7% in the fourth quarter. Meanwhile, full-year adjusted earnings per share (EPS) is forecast to be $9.10 to $9.20, representing growth of 10% to 11% over 2022, excluding pension headwinds in 2023 that won't repeat.
If there was a disappointment about the results, it came from the fact that the midpoint of EPS guidance was maintained, breaking a run of raising guidance in every available quarter since 2021.
Segment |
Third-Quarter Sales |
Third-Quarter Organic Growth |
---|---|---|
Aerospace |
$3.5 billion |
18% |
Home and building technologies (HBT) |
$1.5 billion |
0% |
Performance materials and technologies (PMT) |
$2.9 billion |
3% |
Safety and productivity solutions (SPS) |
$1.3 billion |
(25)% |
Total |
$9.2 billion |
2% |
As such, Honeywell is a mid-single-digit grower; throw in some margin expansion, and its earnings are growing at a double-digit rate in 2023. It's a consistent theme because Wall Street analysts are penciling in 5.5% revenue growth and 9.7% EPS growth for 2024. It's deja vu all over again.
Valuation still matters
The question for investors is whether they are willing to pay a premium for the kind of growth Honeywell is posting.
It's impossible to find a close competitor to Honeywell, so I've picked out a key competitor in each of its current segments and compared the ratio of their forward enterprise value (market cap plus net debt) to their earnings before interest, taxes, depreciation, and amortization (EBITDA).
It shows a stock trading toward the high end of its peer group. As such, the so-called industrial conglomerate discount doesn't apply here. The market knows Honeywell is a high-quality company and is pricing it accordingly.
The question boils down to whether you want to pay an EV of 14.2 forward EBITDA and a forward price to free cash flow (FCF) (based on Wall Street analyst estimates) of 21.2 times FCF for growing revenue at a mid-single digit rate. Focusing on FCF for a moment, management's current long-term target is to grow revenue by 4% to 7% and convert its revenue into FCF at a "mid-teens" rate. Given that FCF conversion was 14% in 2022, and the midpoint of its guidance calls for 14.3% conversion, it's fair to argue that management is aiming to grow Honeywell's FCF at that rate (the revenue growth rate of 4% to 7%) in the future.
Summing up on the valuation question, Honeywell is trading on a forward price-to-FCF multiple of 21.2, aiming to grow FCF at a mid-single-digit rate.
Is Honeywell a stock to buy?
Frankly, it looks like a reasonable proposition. Apologies for obsessing over FCF, but if you flip the 21.2 times multiple, it gives you an FCF yield of 4.7%, and that's, at least in theory, what the company could return to shareholders in the form of dividends or buybacks.
That's fair enough, but if Honeywell is to get a valuation premium, it probably needs to start demonstrating it can grow at the upper end of the 4% to 7% range.
New CEO Vimal Kapur has outlined that Honeywell plans to have $36 billion to $39 billion available for capital deployment in 2023-2025, with $13 billion available for share buybacks and acquisitions and $11 billion to $14 billion in available cash and debt capacity.
It also has a "robust pipeline with plans to execute over the next 12 months" on acquisitions in the $1 billion to $7 billion range and the possibility to "divest 10% of revenue not aligned" to its new structure focused on aerospace, building automation, industrial automation, and sustainability. That's exactly what you might expect an industrial conglomerate to do -- use the cash and financial firepower from its mix of operations to take advantage of acquisition opportunities through the cycle while others flounder.
The success of those plans will probably determine whether the company can improve its growth rate and whether the stock can move meaningfully higher from here. The opportunity is there, but the rich valuation means that Honeywell needs to realize it before the stock starts looking like a value opportunity.