Over the past two years, shares of the industrial manufacturer Honeywell (HON 0.08%) have trounced those of its peers General Electric (HON 0.08%) and United Technologies (UTX +0.94%). On Friday, however, its shares dropped 2.5% when Honeywell failed to beat analysts' third-quarter earnings expectations.
Despite sluggish sales growth in its defense and space business, management described a "path to strong earnings growth" in the year ahead. For investors, Honeywell's temporary pullback could present a buying opportunity.
Running ahead of the pack
Honeywell's strong performance over the past two years has been driven by growth across its entire portfolio of businesses. Up until Friday, the $66 billion industrial giant had surpassed analysts' earnings per share expectations for four straight quarters in a row – not an easy feat. Fueled by steady – albeit modest – economic growth, Honeywell experienced a significant run-up in its stock price that bested its closest manufacturing competitors.
While General Electric and United Technologies, two components of the Dow Jones Industrial Average, outperformed the broad market index, Honeywell actually managed to double the Dow's return over this time frame.
Tepid growth, but rising profits
Key to Honeywell's strong performance has been management's focus on boosting profit margins across the business. For example, in the most recent third-quarter results the company's revenue grew 3.3% versus the same period last year, but operating profits expanded by 9.5%. An emphasis on operational efficiencies has boosted the company's margins:
|
Q3FY12 |
Q4FY12 |
Q1FY13 |
Q2FY13 |
Q3FY13 | |
|---|---|---|---|---|---|
|
Operating Margin |
15.8% |
15.6% |
16.2% |
16.1% |
16.7% |
Source: 10-K
And recent quarters tell only part of the story. Honeywell's stock is up more than 200% since hitting lows in 2009, when the company was in the midst of embarking on a significant "restructuring" initiative. Back then, Honeywell, like many large industrial companies, felt the squeeze of an economic slowdown and started implementing cost-saving solutions. Fortunately, management took to trimming the fat with a paring knife instead of a hatchet. As CEO Dave Cote put it recently in the Harvard Business Review:
In a recession, material costs (direct costs) drop naturally. ... Cutting the costs of people, which in an industrial company usually account for 30% to 40% of total costs, is more difficult. ... So we made sure that any restructuring we agreed to during that period would be permanent – in other words, not solely in response to the recession but, rather, what was best for business efficiency and profitability over the long term – and would have no impact on our ability to outperform in recovery.
In other words, Honeywell avoided a knee-jerk reaction to slumping demand, retained its top-performing employees, and managed to temporarily furlough those that would be needed when the economy bounced back. While nonetheless painful for many employees, this strategy helped the company weather the storm in the short run and appears to have expedited the recovery process.
What you need to know about Honeywell's future
Looking ahead to 2014, management expects to remove another $125 million in costs and predicts that "organic growth will accelerate for Honeywell in 2014." This positive outlook prompted management to raise the bottom end of Honeywell's earnings per share estimate from $4.85 to $4.90 for next year, while the upper end remains at $4.95.
As a result, Honeywell's forward price-to-earnings ratio clocks in at 15.2, nearly even with United Technologies' at 15.3 and slightly above GE's 13.5. Considering all three companies' moderate growth rates, the key differentiator could be Honeywell's ability to continue expanding its margins in the years to come.
While General Electric might have overshadowed Honeywell's earnings announcement on Friday, both companies appear to be on solid footing. Investors would be wise to take a second look.
