Don't Miss the Hidden Value in Honeywell International (HON) Stock

By Markets Fool.com

Honeywell International has a reputation for being one of the best run companies in the industrial sector, and quality rarely comes cheap. However, a deeper look at its guidance reveals a key metric that makes Honeywell look like one of the most attractive companies in its sector. Let's take a closer look.

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Honeywell International: Quality but at a price
First of all let's acknowledge that Honeywell isn't a conventionally cheap stock -- after all it trades on a trailing P/E ratio of 19.5 times earnings, compared to peers like General Electric Company on 17.3 times, or its closest peer, United Technologies on 18 times. However, quality rarely comes cheap. For example, a comparative DuPont analysis of Honeywell International and United Technologies demonstrates the higher return on equity generated by Honeywell -- indicative of a higher quality of execution.

In addition, a breakout of segmental return on assets, or ROA, for Honeywell shows that Honeywell generates higher ROA in its aerospace business than United Technologies' aerospace businesses do.

So, if Honeywell International is priced at a premium that already reflects its quality, what makes the stock look attractive?

Underlying guidance is good
I'll get straight to the point. Here is what CFO Tom Szlosek said about 2015 on the fourth-quarter earnings call: "Free cash flow is expected to be in the range of $4.2 billion to $4.3 billion up 8% to 10% from 2014 with CapEx investments peaking at roughly two-times depreciation."

He went on to highlight his view that a normalized rate of capital expenditures would be around 1.25 times depreciation. Why is this so important?

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First, the forecast free-cash flow figures put Honeywell on an attractive valuation in itself. Taking the midpoint of guidance and equating it to enterprise value (market cap plus net debt), or EV, puts it on a forward free cash flow to EV yield of 5.2%. In other words, the company will generate 5.2% of its value in free cash flow -- not bad in a world where the U.S. 10-year treasury yield is currently around 2.4%

Guidance implies ongoing strong cash-flow generation. Data source: Honeywell International presentations

Stronger than headline number indicates
Second, this amount of free cash flow generation is all the more impressive because it'scoming in a period when Honeywell is making significant capital expenditures in order to generate growth -- particularly in its performance, materials, and technologies (PMT) segment.

As Szlosekpointed out at the Barclays Select Industrial conference, capital expenditures are intended to peak at "at two-times depreciation" in 2017. He then outlined his expectation that the capital expenditures/depreciation ratio would come down in 2016, and then "normalize" to a ratio of 1.2 times.

A look at the historical ratio of capital expenditures to depreciation demonstrates that "two-times" depreciation during 2015 actually implies a significant amount of growth-based investment.

Data source: Honeywell International presentations

Essentially, companies make two kinds of capital expenditures: maintenance and expansionary. As assets depreciate they will need to be replaced, so maintenance capital expenditures can be equated with depreciation.

Therefore, any capital expenditures in excess of depreciation can be looked at as expansionary capital expenditures. It's usual for a company's long-term capex/depreciation ratio to be above one, because companies are expected to seek growth.

Growth to come
Third, the expansionary capex is expected to help fuel some impressive growth in future. Investors may already know that Honeywell's management has guided toward double-digit earnings growth to 2018, with segment margins expected to increase to a range of 18.5%-20% by 2018, from 16.6% in 2014. Revenue is expected to grow at a compound annual rate of 3.3%-6% from 2014-2018.

The investment proposition
All told, Honeywell currently trades on a forward free cash flow to EV yield of 5.2%. An even more impressive number when you consider that this is a year when Honeywell is investing heavily in capital expenditures in order to drive future growth.

The company's exposure to aerospace, construction, and materials means it will always be correlated to global growth. So if you are positive on the global economy, and looking for some cyclical exposure, Honeywell offers a compelling mix of growth and cash flow generation. The stock is a lot cheaper than its P/E ratio suggests.

The article Don't Miss the Hidden Value in Honeywell International (HON) Stock originally appeared on Fool.com.

Lee Samaha has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. 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.