Summary
- Covid-19 is causing chaos across every industrial market, but Honeywell's commercial aerospace, oil/gas, process automation, and non-residential construction customers may be especially vulnerable to a more prolonged decline/recovery cycle.
- Honeywell is reportedly pushing for aggressive concessions from suppliers; arguably a necessary move to offset what could otherwise be a significant decremental margin shock.
- Honeywell has already recovered a lot of ground from the lows of the panic, but the shares look attractively priced on a long-term basis.
The grim reality is that nobody really knows anything right now when it comes to assessing the impact of Covid-19 on the U.S. economy (let alone the global economy), nor how long it will take to get back to business as usual. While the market has recovered pretty strongly over the last couple of weeks, taking Honeywell (HON) shares up more than 40% from the point of peak panic, I don’t necessarily think we’ve seen the last shoe drop. Given the difficulties in predicting end-market demand in this environment, I’d be surprised if Honeywell didn’t pull guidance entirely. I also see a risk of sharp decremental margins – probably not in the first quarter, but possibly in the second and third quarters – and I believe that may shock the Street and rattle sentiment again. On top of that, a significant chunk of Honeywell’s revenue looks to me to be at risk beyond just a sharp correction that resolves by year-end.
All of this doom and gloom aside, these are the times that value investors wait for. Honeywell’s valuation isn’t quite where I’d like to be after this strong rally, but it’s good enough for this as a long-term holding and certainly at a level where I’d watch this for any potential “double-dip” in the industrial sector as companies start reporting March quarter earnings.
Trying To Drive Through Dense Fog … At Night
The end-markets for multi-industrials like Honeywell are in turmoil now, with many businesses shutdown or severely curtailed, and not much clarity on the path back over the next few months.
Within that uncertainty, I’m still willing to make some predications and estimations as it concerns Honeywell.
Aerospace is going to be challenging, and what was once a growth crown jewel for companies like Honeywell, Eaton (ETN), and Parker Hannifin (PH) has definitely lost some luster. The issues with the Boeing (BA) MAX are well known, but the potential damage to the commercial aftermarket may be less well-appreciated. For starters, about 20% of Honeywell’s aerospace revenue is driven by flight hours, and with fleets grounded across the world, that means no flight hours. On top of that, the impact of the Covid-19 outbreak on airlines could lead to order delays or cancellations, throwing further uncertainty into build schedules.
Oil/gas, process automation, and industrial automation are likely to be pressured as well. We’ve seen major oil companies cutting capex budgets by 20% or more in response to weak prices, with smaller independents cutting budgets by 50% or more. I don’t believe that companies like Emerson (EMR) and Honeywell are necessarily going to see demand destruction, but projects are definitely getting pushed out. Likewise, in a world where factories are shuttered and supply chains are in turmoil, logistics and warehouse automation projects are likely to get pushed out.
Last and not least is the non-residential construction market. This is probably the most controversial market right now. Construction activity has definitely plunged as states and countries have issued shutdown orders, but it’s unclear how quickly things may recover. We were already looking at a thinner funnel of new projects (after years of strong investment in new non-residential construction), and now companies have slammed on the brakes on new investments … and may well decide to wait and see how things shake out after global economies get back up to speed after these shutdowns. On the positive side, Honeywell has a good skew towards services (55% of the Building Tech segment), and those are likely to hold up better.
Honeywell Not Standing Idle
Honeywell isn’t taking this shutdown lying down. As I said in the open, I think Honeywell could be vulnerable to some margin shock, as the company sees significant decremental margins on this sudden and unexpected shutdown – Honeywell is a top-notch operator, but there’s hardly any manufacturing company this large that could adjust its manufacturing and cost base quickly enough to avoid serious decrementals in the face of such a significant unplanned volume decline.
But it sounds like Honeywell is moving aggressively to fix this. A widely-circulated report from Barrons describes a memo that Honeywell recently sent to its suppliers demanding some startling concessions. According to the report, Honeywell is insisting on 30% across-the-board price cuts from suppliers effectively immediately, as well as more liberal payment terms, rebates on future order volume growth, holding Honeywell inventory at suppliers, and immediate resolution of outstanding claims against Honeywell.
Is this an example of doing what is necessary in extraordinary times, or is this an example of “don’t let a crisis go to waste” and Honeywell trying to turn the screws on suppliers that are under intense strain right now? Maybe it’s both; I don’t expect Honeywell to absorb all the pain itself, but these demands seem quite aggressive to me, and I’ll be curious how many suppliers agree to them.
