Honeywell: A Good Long Term Bet
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Honeywell International Inc (NYSE: HON) is a diversified technology and manufacturing company, serving customers worldwide with aerospace products and services, control, sensing and security technologies for buildings, homes and industry, turbochargers, automotive products, specialty chemicals, electronic and advanced materials, process technology for refining and petrochemicals, and energy efficient products and solutions for homes, business and transportation. The company enjoys global market leadership in a broad line of components and controls technologies.
The company’s management has been successful in driving operational improvements while also investing in R&D (up substantially versus last cycle as a percentage of revenues) and rationalizing the portfolio through reasonably-priced acquisitions. Last month, company reported impressive Q2 results; sales were up 3.8% YoY and 1.5% sequentially despite intense macro headwinds, EPS was up 14% and operating margins were 90bps above the normalized year ago rate and 60bps sequentially. Improved structural growth and energy efficiency has been the demand driver of 50% of revenues. These improvements were largely impacted by the company’s strategic focus on higher-growth segments of major end markets. Further, I believe that the company has strong long term growth prospects as it has ample near and long term drivers like strong balance sheet, flexible free cash flow, recovery in air travel and in airline capacity requirements, process industry capital expenditures.
Honeywell’s UOP segment sales comprise of ~40% petrochemical, ~30% refining, 15% natural gas, 15% manufacturing of adsorbents/aluminas. UOP have been constantly looking for solutions that can dramatically increase both throughput and efficiencies for refiners as energy supplies causing market pricing swings. Further, demand for new cracking chemicals and technologies has been increasing at a very high pace with oil supplies become heavier and more sulphurous.
Base oil demand is growing 1.3% per annum and UOP is experiencing 10%-12% growth while industry peer growth is only ~4%. In the coming four years the demand for base oil is expected to increase by 9 million barrels which implies the requirement to install 36 new refineries (assuming each refinery’s capacity to be 250,000 barrels per day, each refinery will cost around $10 billion). UOP solutions can increase the margin dollar per barrel by $2 to $15, resulting in a 100% to 200% increase. I believe that the company will be able to capture this huge market opportunity given its market leadership as 95% of the world's refiners already use its technology and efficient solutions.
Although a near-term upside is unlikely as most renewable technologies are still in the “seed planting” stage, the long-term outlook has never been more favorable as ongoing projects are expected to bear fruit in the coming years and catalysts adoption will continue to fuel the growth machine. Moreover, emerging markets like China, India and Middle East are expected account for greater than 50% of global additional refining capacity over the next five years and Honeywell has already have its footprint over these areas. Thus, I believe the company is on its way to achieve sustainable growth for several years FY13 onwards.
Additionally, I expect Honeywell’s aerospace business will continue to benefit from strong higher build rates by commercial aircraft producers. The Company is currently trading at forward PE of 11.69x which is at ~ 14% discount from its peers like Tyco International Ltd. (NYSE: TYC). Although Tyco is expected to grow its EPS similar to Honeywell (~10.5% next year) but it pays less dividend than Honeywell (Tyco 1.8%, Honeywell 2.5%). Therefore, I believe that Honeywell’s valuation at discount to its peers is not justified, given its impressive operating margin target of 16-18% and strong dividend yield. Further, I believe the company’s long cycle acceleration, expanded productivity initiatives and flexibility to execute on both acquisitions and buybacks make it a good long term investment.
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