Honeywell International (HON) Analyst: Benjamin Yang Spring 2014

Recommendation: BUY Target Price until (12/31/2015): $103

1. Reasons for the Recommendation

I.1 Recommendation

Honeywell remains competitive in all four of its major segments and expects significant revenue gains in the coming years due to a combination of strategic mergers and acquisitions (M&A) and increased operational efficiencies. Overall firm performance is closely tied to the global economy, which is expected to continue improving over the time period of interest. Increased interest in greenhouse gas emissions and fuel efficiency also provide opportunities for some of Honeywell’s products to gain market share, especially in the areas of refrigerants and turbocharger engines.

I.2 Positives

There are several reasons behind the recommendation for Honeywell, including favorable segment indicators, high expected revenue growth associated with mergers and acquisitions (M&A), and expected net income margin improvement in the near future. The broad scope of Honeywell’s products results in a strong correlation with major global economic cycles. For example, the segment is closely related to commercial air travel, the Automation and Controls Solutions segment (ACS) segment is correlated to the housing market, the Performance and Materials Technologies (PMT) segment is tied to various manufacturing industries, and the Transportation Systems segment is associated with automobile sales. Given the continued recovery from the 2008 recession, each of these industries has a positive outlook for the time period of interest. In addition, global awareness of environmental concerns creates opportunities for Honeywell’s product portfolio to capture greater market share. A significant portion of Honeywell’s product lineup addresses customer demand to improve energy efficiency and decrease greenhouse gas emissions. Examples of such products include turbocharger engines, smarter environmental controls, and low-greenhouse-gas refrigerants.

In addition, Honeywell is pursuing a strategy of aggressive revenue growth through strategic M&A to better align its business with future market demands. In March 2014, Honeywell announced plans at its investor’s day event to spend $10 billion in M&A (22% of 2013 total assets) through 2018, with a stated goal to double EPS by 2018. This value roughly doubles their M&A activity compared to previous five years. Their past acquisitions do not signal a significant departure from Honeywell’s core businesses but reposition its segments for better alignment with future customer priorities. Examples include the purchase of Russell Thomas, which specializes in natural gas processing and enables Honeywell to access gains in the growing domestic natural gas industry. The acquisition of , a radio frequency identification (RFID) company, provides opportunities for Honeywell’s ACS segment in the growing field of information technology. Conservative estimates on associated revenue growth by this analyst assuming only short-term revenue growth in segments with planned M&A activity followed by primarily organic growth that follows the industry still results in a significant 49% growth in EPS by 2018. Honeywell has specified plans to perform M&A activities in digestible $1 billion pieces, which allows time for incremental adjustments to earnings and analysis of M&A targets by future analysts as Honeywell executes its plan.

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Honeywell International (HON) Analyst: Benjamin Yang Spring 2014

Honeywell had strong net income growth during 2011-2013 despite moderate revenue growth, primarily thanks to improvements in operational efficiencies. With the sale of its underperforming Friction Materials business and continued efforts for further improvements, further margin improvements are expected for 2014 and 2015, which will amplify the effects of projected sales growth.

I.3 Negatives

Government and defense-related budget cuts represent the strongest obstacle to continued growth in Honeywell’s Aerospace segment. Overcoming this challenge will require generating new sales with foreign governments or a reversal in recent trends to cut domestic government spending. Neither outcome is guaranteed, though Honeywell continues to pursue foreign governmental sales for non-defense products. There are signs for optimism: a recent Department of Defense contract award worth $43.2 million for naval electronic surveillance systems support is a positive indicator that Honeywell is still competitive in government sales (Smith 2014). This analyst’s projection assumes significant decreases in defense and space revenue in 2014, followed by gradual improvements thereafter. A revised projection is recommended if the declines in defense and space sales continue to accelerate in 2015.

The significant increase in M&A activity compared to the previous five years means that organic growth may be more challenging to track. Most of the M&A activities are in the ACS and PMT segment. This analyst recommends continued monitoring of segment-level organic revenue growth numbers to ensure that they are at least in the 1%-4% range through 2015. This outcome would indicate that they are keeping pace with market growth. This analyst would recommend a re-evaluation for new underlying weaknesses if these segments fail to meet this organic growth goal during its M&A endeavors.

While operational efficiencies are expected to continue in the near term, further increases in net income margins are questionable beyond 2015 as the rollout of various efficiency-enhancing programs wind down (Honeywell Corporation 2014). Further growth in margins is still possible by selling underperforming units but the extent of such improvement is uncertain. This analysis assumes a gradual increase in net income margin that levels out in 2016, which is a partial reason for the lower 2018 EPS estimate when compared to Honeywell’s stated company goals. If net income margins fail to improve in 2014, then a downward correction of the target stock price is warranted.

2. Company Analysis

2.1 Company Overview

Honeywell is a diversified technology and manufacturing company that operates in a variety of industries. It has for segments: Aerospace (32% of 2013 revenue, 40.3% of 2013 operating income), Automation Controls Solutions (ACS, 42.2% of revenue, 39.4% of operating income), Performance Materials and Technologies (PMT, 16.4% of revenue, 20.4% of operating income), and Transportation Systems (9.5% of total revenue, 7.6% of operating profits). It competes internationally, with 55% of sales coming from outside of the . Many of Honeywell’s strengths, opportunities, strengths, and weaknesses are typical to those of large conglomerates, as detailed in the following subsections.

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Honeywell International (HON) Analyst: Benjamin Yang Spring 2014

2.2 Company Strengths

As a large diversified company, Honeywell is able to operate in a variety of industries where economies of scale and ability to handle vast regulations are a requirement. This criterion creates a naturally moderate to high barrier of entry. It also supplies products to stable industries, such as the aerospace or automotive industries. Honeywell’s customers have a high switching cost if they were to change the associated products that supply these industries at the original equipment manufacturer (OEM) level. As a result, Honeywell is highly likely to sustain existing advantages in these industries.

Honeywell’s extensive exposure results in company growth that is highly correlated with broader market conditions. The recovering global economy therefore provides tailwinds to major Honeywell segments. A significant fraction of ACS products are tied to the housing industry, which is expected to continue its recent trend of recovery and growth (Edwards 2013). Sales in Aerospace are linked to commercial travel, where strong growth is expected in the near future (Soshkin 2013). Global trends in demand for environmentally-friendly product solutions provide momentum for growth in associated PMT and Transportation Systems products (Yang 2013) (McBee 2012).

In addition, Honeywell is highly liquid, holding over $6.4 billion in cash and equivalents (14.1% of assets) in 2013. This liquidity provides ample opportunity for strategic M&A as a source of revenue growth and further diversification. Honeywell is already utilizing this advantage to create promising sources of revenue growth, such as purchases in the areas petroleum refinement (Thomas Russell) and mobile computing (Intermec) (Honeywell Corporation 2014). In Honeywell’s 2013 4th quarter conference call in March 2014, it announced intentions to double spending in M&A to $10 billion or more over the next five years, which would increase expected revenue from 2013’s $39 billion to $59 billion in 2018 (Black 2014).

With 13% of its sales in growth regions in Asia, Honeywell is well-poised to have a strong presence in emerging economies in the region (Honeywell Corporation 2014). A significant fraction of these sales are in the automotive, energy, and construction markets, which are expected to experience high levels of growth in the future (Honeywell Corporation 2014) (SpecialChem 2014).

2.3 Company Risk Factors

There are several risk factors that may prevent Honeywell from meeting the expectations outlined in this analysis. These risks include the recent dependence on margin improvements to increase revenue, the price pressures volatility on raw materials, and exposure to increased liabilities due to existing lawsuits.

During the time period of 2011, 2012, and 2013, Honeywell produced net sales of $36.5 billion, $37.7 billion, and $39.1 billion respectively. These numbers correspond to a sales increase of 3.1% in 2012 and 3.7% in 2013. Due to improvements in margins, however, net income for these years were $2.1 billion, $2.9 billion and $4.0 billion, corresponding to improvements of 41% in 2012 and 35% in 2013. Therefore a significant source of company growth is dependent on margin improvements through increased operational efficiency. This trend can be observed in the net income margin, which improved by 2.1% in 2012 and 2.3% in 2013. The favorable price projections in this analysis assume that similar improvements will continue, albeit at a moderated pace of 0.7% in 2014 and 0.3% in 2015 before leveling out in 2016

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Honeywell International (HON) Analyst: Benjamin Yang Spring 2014

and beyond. Assumptions and projections at the segment level for operational improvements were used to arrive at these net income margin improvements, which are slightly more conservative than Honeywell’s own projections.

Another risk facing Honeywell is price pressure in both raw material costs and product pricing. Prices for raw chemical materials for Honeywell’s PMT segment products and steel for its Transportation System segment products are particularly difficult to predict (Honeywell Corporation 2014). Adverse pricing can decrease Honeywell’s margins, which are of significant importance to the firm’s profitability as described above. Honeywell has been successful in controlling these prices through financial instruments in the past, however, and is expected to continue doing so in the future. On the product pricing side, cost- conscious customers are exerting downward pressure on some of Honeywell’s products, such as refrigerants (Theo 2014). Honeywill hopes to overcome this pressure through unique superior products, such as its low-global-warming HFO-1234yf refrigerant (PR Newswire 2014).

One final source of uncertainty with Honeywell lies in asbestos-related environmental liabilities related to prior acquisitions. Honeywell currently has approximately $400 million in reserves for this purpose but it is unclear what the final liabilities will be once all the claims are filed (Honeywell Corporation 2014). This issue is expected to remain through 2018, covering the entire period of interest in this analysis.

3. Industry Analysis

3.1 Aerospace

The aerospace industry consists primarily of aircraft manufacturing and sales, which constitutes over half (58.9%) of $173.7 billion industry revenue. This portion of the industry is largely dominated by , Airbus, and . Honeywell’s Aerospace segment focuses on providing aircraft engines and components such as lighting, environmental controls, and navigation equipment. It competes primarily with firms such as United Technology and , and mostly sells products to OEMs (Soshkin 2013). As such, Aerospace segment performance is related to both manufacturing of new aircraft as well as maintenance and repair of existing air vehicles. Pricing competition is fierce, as OEMs hold significant buying power. The threat of entrants, however, is low due to the high technical requirements and economies of scale required to compete in this space.

The aerospace industry experienced slow growth in the recent past, 0.6% between 2008 and 2013, but expansion is expected accelerate at a rate of 3.8% per year for the subsequent five years. The actual growth depends on two competing forces. Sales associated with commercial aircraft are expected to grow as worldwide passenger traffic is expected to rebound with the economy (Soshkin 2013). Growth in commercial aircraft is expected to be offset in part from expected decreases in government spending, especially in the defense segment (Hugel 2013).

3.2 Automation Control Solutions

Honeywell’s ACS products provide environmental controls for buildings as well as some industrial processes. The segment is most closely tied to the housing industry. The industry is expected to continue its rebound from the recession and grow at an annual rate of 8.3% (Edwards 2013). Price competition is

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Honeywell International (HON) Analyst: Benjamin Yang Spring 2014

fierce in this industry as product standards have limited differentiation opportunities. In addition, there is the ever-present threat of low-cost overseas competitors. The barrier to entry is low, though large firms such as Honeywell hold an advantage due to economies of scale.

Two opportunities for industry growth are housing growth in emerging markets and increased emphasis in energy efficiency. Multinational firms such as Honeywell are well-positioned to capitalize on the continued flourishing of the housing market in emerging economies. The increased interest in energy efficiency creates a growing interest in the performance of products such as thermostats, where Honeywell commands a 38.6% market share (Windle 2013).

3.3 Performance Materials Technologies

The PMT segment of Honeywell provides a variety of chemicals for industrial uses, with an emphasis on hydrocarbon processing and refrigeration. The manufacturing of these inorganic chemicals is a $37.3 billion business that is highly segmented (Phillips 2014), with no firm commanding more than 10% of industry revenue. The largest firms in this industry are E.I. Dupont de Nemours and Company and Dow Chemical Company, which hold the market shares of 7.4% and 5.0%, respectively. The industry is expected to grow at a rate of 3.9% as manufacturing-related demand increases. Increased global warming concerns provide an opportunity for firms with environmentally-friendly products to grow their market share.

While the technology aspects of most products are mature, competition remains moderate due to a high barrier to entry. The production operation is very capital intensive and requires conformation to complex environmental regulations, which provide an advantage of large, established firms over new entrants. Size is also important to create economies of scale and weather the high volatility in both supplier cost and customer demand. Therefore, firms such as Honeywell who have a reasonable stronghold in the industry should be able to maintain their advantages with little difficulty.

3.4 Transportation Systems

Turbocharger engines are the primary product in Honeywell’s Transportation Systems segment. The top three firms in the turbocharger industry in 2013 were BorgWarner (28.5% market share), Cummins Inc. (27.3% market share), and Honeywell International (22.8% market share) (McBee 2012). These three firms hold substantial advantages over the remaining competitors due to economies of scale and solid reputations, which form the most significant barrier to new entrance.

The turbocharger industry is expected to grow at a rate of 2.5% between 2013 and 2018, fueled by expected strong growth in automobile sales worldwide during this time period. Increasing fuel efficiency standards are the greatest source for potential growth in market share for companies that are able to develop superior products. Improved engine performance, lower cost due to efficient operations, and a strong reputation will be the key for continued success against industry competition.

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Honeywell International (HON) Analyst: Benjamin Yang Spring 2014

Appendix: Inputs into valuation using multiples

* Analyst's own calculations. Source of basic data: company's 10-K, 10-Q, and Yahoo! Finance

Notes on Income Statement Projections:

A multiples analysis was used to value Honeywell at $94.32/share in 2014 and $102.62/share in 2015. Additional details are provided in Appendix A. The predicted revenue and net income numbers were derived by projecting sales and associated costs on a segment-by-segment basis to arrive at overall figures. The analysis assumes a moderation of recent trends in net income margin improvements and modest long term sales growth.

Segment growth rates are determined based on industry report projections when available. Growth rates are moderated in ACS and PMT to reflect expected decreases in acquisition rate, increased competition, and technology change.

Costs associated with segment sales experience a similar rate of decline throughout 2016 as those observed in 2012 and 2013. Long-term projections mentioned in the text of this analysis assume a steady percent-of-sales value beyond 2016. Tax rate is found by finding the average tax expense between 2004 and 2013, with the highest and lowest outliers removed.

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Honeywell International (HON) Analyst: Benjamin Yang Spring 2014

Bibliography

Anderson, David. Honeywell 2013 Q4 Conference Call (January 23, 2014).

Black, Thomas. "Honeywell's five-year M&A spending to double to $10 billion." Bloomberg News, March 5, 2014.

Edwards, Jeremy. Home Builders in the US. IBISWorld Industry Reports, 2013.

Honeywell Corporation. "2013 10-k Filing." 2014.

Hugel, Eric. Industry Surveys: Aerospace and Defense. S&P Capital IQ, 2013.

McBee, Josh. Turbocharger Manufacturing in the US. IBISWorld Industry Reports, 2012.

Phillips, Jocelyn. Inorganic Chemical Manufacturing in the US. IBISWorld Industry Reports, 2014.

PR Newswire. "European Commission's Top Scientific Body Concludes that Honeywell's Low-Global- Warming Refrigerant is Safe for Use in Automobiles." PR Newswire, March 17, 2014.

Smith, Rick. "Pentagon Awards Nearly Three Dozen Defense Contracts." The Motley Fool, March 28, 2014.

Soshkin, Maksim. Aircraft, Engine, and Parts Manufacturing in the US. IBISWorld Industry Reports, 2013.

SpecialChem. "APAC to Witness High Growth in PA Market Due to Rising Demand in Auto Market of and ." SpecialChem For Polymers, April 2, 2014.

Theo, Francis. "Firms Pinched by Pressure to Hold Down Their Prices." Wall Street Journal, February 4, 2014.

Windle, Sean. Thermostat Manufacturing in the US. IBISWorld Industry Reports, 2013.

Yang, David. Petroleum Refining in the US. IBISWorld Industry Reports, 2013.

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