When sales growth is difficult to come by, a company can either get creative or become lazy. The former means adopting a strategy of cost-cutting, productivity improvements, and a focus on generating efficiencies so as to improve margins and profitability. The latter equates to buying top- and bottom-line growth through M&A activity and requires either strong cash flow or an ability to leverage up a company's balance sheet.
At Honeywell (NYSE:HON), the company's management seems to be doing a bit of both. This is a major plus for its investors, since it means that, quite simply, it's not relying on one strategy to cover up for its lack of sales growth. And with Honeywell's core organic sales rising by just 1% in the 2015 financial year, it's clear that a program of change is required to boost its top line.
With Honeywell having increased its margins by 220 points versus the 2014 financial year, major restructuring and changes to the business model are having a positive impact. While there's more to come in this respect, as evidenced by Honeywell's guidance for a rise in margins of 80 to 110 basis points for 2016, there is always an endpoint to productivity gains and cost-cutting. As such, this focus on improved margins may have further to run but is more of a short-term rather than long-term catalyst.
Looking further ahead, Honeywell's cash flow is likely to be the key to its ability to grow earnings per share at a double-digit rate, having done so in each of the past six years. With free cash flow conversion rising to 91% in 2015 and standing at $4.4 billion versus $3.9 billion in 2014, this provides Honeywell with the resources to engage in further M&A activity.
Although this was termed a lazy way to grow sales and profit, it seems to be a sensible strategy for Honeywell to pursue. Elster, a global leader in gas heating, controls, metering, and advanced technologies, is currently being integrated into the business. Meanwhile, a handful of other acquisitions have been made in the last year, such as Com Dev and Datamax-O'Neil (which manufacture space-based communications components and printers, respectively). Together their cost totals over $6 billion and they are a key reason that Honeywell's long-term profit outlook remains positive.
Additionally, Honeywell's exposure to emerging markets is likely to be a major factor in its continued success. While in the short run there is the potential for currency headwinds from the stronger dollar, in the longer term there is huge potential in this space. For evidence, see Honeywell's Q4 update, with its automation and control solutions division reporting a rise in sales in China of over 10%, while the company remains bullish regarding its potential in India, too. With the performance of the U.S. market being somewhat stale, having a growing focus on non-U.S. markets is likely to be a positive catalyst on Honeywell's earnings.
With Honeywell trading on a forward P/E of 14, it appears to offer good value for the money; the S&P 500 has a forward P/E of 16.2. However, Honeywell's potential for capital gains is more evident when its EV/EBITDA ratio of 10.9 is taken into account, and with the company yielding 2.3% with a dividend payout ratio of only 36%, it seems to be fairly valued given its prospects for double-digit annual earnings growth over the medium term.
Undoubtedly, Honeywell's performance materials and technologies segment is acting as a major drag on its overall performance. With sales falling by 12% in Q4 versus the comparable period from the previous year, it's compounding the 3% fall in sales in Honeywell's automation and control solutions department. However, with sales rising by 4% in the company's aerospace division and the prospect of further margin expansion in the short run, M&A activity, and a further pivot toward faster-growing emerging markets for the longer term, Honeywell seems to be all set to shine.
Robert Stephens has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.