Have you ever looked at an industrial conglomerate like Honeywell International (NYSE:HON) and settled on looking at segmental margin as the key indicator of each of its segments' prospects going forward? Or even decided that the company's investment and acquisition activity should be centered on the segment with the highest margin? If so, then you could be looking at things the wrong way. Arguably, the most important number to look at is segmental return on assets, or ROA. Let's take a look at why, and what the ROA numbers mean for Honeywell International.
Why return on assets matters
ROA, as defined here, is a segment's profits divided by its assets. It measures how much return a company is generating from its asset base. It's a more useful measure than profit margin. Why? A company could have a segment with a large profit margin, but if it requires a large asset base to generate profits -- in other words, it has a low ROA -- then the company might more productively invest in a segment that has a smaller profit margin but a higher ROA.
A good example of this is General Electric, whose power-and-water and aviation segments tend to generate pretty similar profit margins. However, a look at ROA indicates that General Electric gets more out of investing in assets in its power-and-water segment -- suggesting that the acquisition of Alstom's power-and-grid assets is a good idea.
Honeywell International's return on assets
Honeywell International reports out of three segments. The aerospace segment produces aircraft engines, avionics, and various aerospace products and services. As such, it competes with companies like General Electric, United Technologies, and Garmin. The segment also makes automotive turbochargers and competes with BorgWarner.
Its Automation and Control Solutions, or ACS, segment delivers products and services for residential and commercial buildings and industrial facilities. Competitors include 3M, Siemens, and Johnson Controls. The latter is making bullish noises about its building markets in 2015 -- a good sign for Honeywell.
The performance, materials, and technologies, or PMT, segment develops and manufactures advanced materials and process technologies and competes with companies like BASF, DuPont, and Emerson Electric.
In terms of profit margin, all three segments look pretty similar, with margins in the range of 14%-19% during the last three years.
However, a look at ROA reveals a different story. Aerospace is clearly its most productive segment, with the other two segments lagging behind.
One possible clue to why this might be the case lies in the fact that the aerospace segment has a far larger component of sales coming from services. In fact, in 2014 services made up 31% of aerospace segment sales, against 8.8% for ACS and 17.8% for PMT. As you can see above, the PMT segment's ROA is higher than ACS -- in line with the percentage of services revenue.
Another useful way to look at things is to analyze free cash flow generation from assets. In this case, I'm using segment earnings before interest, tax, and depreciation, or EBITDA, minus capital expenditures as a proxy for free cash flow. The analysis reveals that aerospace is the most cash-generating segment, but the difference in productivity -- at least on this measure -- between PMT and ACS is reduced. This suggests that ACS is a relatively capital-intensive business.
All told, investors should look toward the expansion of acquisition activity in Honeywell's aerospace segment. In addition, an expansion of services sales in all three segments is likely to see some increased ROA: something to look forward to in 2015.