Reasons for Caution.
... HP continues to skate closer to the brink with what seems like an uncoordinated acquisition strategy. How 3Com, 3PAR, and Palm all fit together, we do not know. These acquisitions will dilute focus at a time when a new CEO is coming on boardwith his own ideaswhile new board members a.s.sume their seats, and while compet.i.tive pressures mount. Mark Hurd"s arrival at Oracle to run their hardware business (formerly, Sun) makes them a suddenly formidable compet.i.tor, as if there wasn"t enough compet.i.tion already. HP has never succeeded in the software business, so new ventures there add as much risk as reward in our opinion. Finally, we"ve long been annoyed by the company"s conservative dividend policy, which brought no increases in eleven years, a clear contrast to most of the companies on our 100 Best list and surprising for a company that could have afforded more. The company just announced its intentions to give "double digit increases" for the foreseeable future, although the dollar amounts involved will be small. In short, HP has done a lot to mystify, and frankly, alienate shareholders, but that said, prospects are bright should the company get its ducks in a row.
GROWTH AND INCOME.
Honeywell International, Inc.
Ticker symbol: HON (NYSE) S&P rating: A Value Line financial strength rating: A++ Current yield: 2.7%.
Company Profile.
Honeywell is a diversified technology and manufacturing company, developing, manufacturing, and marketing aeros.p.a.ce products and services (40 percent of sales); control technologies for buildings, homes, and industry (31 percent); automotive products (15 percent); and specialty materials (14 percent).
Honeywell operates in four business segments: Aeros.p.a.ce, Automation and Control Solutions, Specialty Materials, and Transportation Systems.
The Aeros.p.a.ce segment primarily makes c.o.c.kpit controls, power generation equipment, and wheels and brakes for commercial and military aircraft. It also makes jet engines for regional and business jet manufacturers. Products include avionics, auxiliary power units (APUs), aircraft lighting, and landing systems. Demand for the company"s aircraft equipment is driven primarily by expansion in the global jetliner fleet, particularly jets with 100 or more seats. Since 1993, the global airliner fleet has grown at a 3 percent annual pace. The Aeros.p.a.ce segment is also a major player in the $35 billion global aircraft maintenance, repair, and overhaul industry, which is growing at a 2.2 percent annual rate.
Honeywell"s Automation and Control Solutions segment is best known as a maker of home and office climate controls equipment. It also makes home automation systems, sensing and combustion controls for heating, A/C and other environmental controls, lighting controls, security systems and sensing products, and fire alarms. This segment produces most of the components of what is known in the trade and advertising lingo as a "smart building."
The Specialty Materials operation makes specialty chemicals and fibers, which are sold primarily to the food, pharmaceutical, and electronic packaging industries.
The Transportation System segment consists of a portfolio of brand name car-care products, such as Fram filters, Prestone antifreeze, Autolite spark plugs, and Simoniz car waxes. The unit also manufactures braking systems for large trucks and service vehicles.
Financial Highlights, Fiscal Year 2010.
Honeywell is in several economically sensitive businesses, and that showed up big in 2009 results, which in terms of revenue were almost 20 percent below 2008. As many of the company"s products serve "long cycle" businesses like aircraft and commercial building construction, FY10 sales were up but still remained more than $3 billion, or more than 10 percent off the 2008 peak. Not surprisingly, earnings "troughed" in a similar manner, except that 2010 was worse than 2009 and almost a third lower than 2008. Orders and business trends started to pick back up in the second quarter of 2010, and 2011 guidance, while short of 2008 levels, is close to 2007 and historically strong. During the downturn, the bulk of the earnings declines were in the Aeros.p.a.ce and Transportation segments; the Automation and Control segment remained fairly steady despite its dependence on the large-scale construction industry.
Reasons to Buy.
We like where Honeywell is positioned with regard to the growing awareness of the value of energy efficiency. Over the next few years we see a lot of movement toward green practices in building design and use, and no one has a stronger portfolio of lighting and temperature control systems than Honeywell. Over half of the company"s portfolio, across all four segments, is in the area of energy efficiency. The company also has a valuable distribution network and existing customer base, as they"ve been in this business longer than anyone else. If Honeywell can leverage their position here with the right message (and a.s.suming the construction market begins to turn around), the company could experience strong growth, particularly in the Automation and Controls segment.
Honeywell will be part of the consortium responsible for the development and deployment of the next-generation air traffic control system commissioned by the FAA. This is a long-term program and Honeywell is not the primary contractor, but this system will likely be the model for the modernization of air traffic systems worldwide.
The company has a solid balance sheet and partic.i.p.ates almost exclusively in high-margin businesses. Economic recovery should further accelerate HON"s earnings growth.
Reasons for Caution.
Honeywell has a lot of compet.i.tion, particularly in the aeros.p.a.ce and transportation sectors, and is sensitive to economic cycles, especially in these industries. Many of the industries Honeywell sells toin particular, the aeros.p.a.ce industryare and probably will always be low-growth businesses. These segments dilute our excitement about the building controls industry and its implied play on energy efficiency.
CONSERVATIVE GROWTH.
IBM.
Ticker symbol: IBM (NYSE) S&P rating: A+ Value Line financial strength rating: A++ Current yield: 1.68%.
Company Profile.
Big Blue is the world"s leading provider of computer hardware and services. IBM makes a broad range of computers, mainframes, and network servers. But the company has morphed over the years into a software and services company; the company is number two behind Microsoft in the software business. IBM is also an innovation and new product development leader, for the past seventeen years leading the world in the number of U.S. patents issued.
In 2009, IBM derived over 75 percent of its revenue and 82 percent of its income from the Software and Services businesses. Although now only 17 percent of the business, the company continues to design and produce mainframes and has its label on five of the top ten supercomputers in the world. They also produce high-margin commercial servers and enterprise-level installations, but in recent years they have exited the lower-margin hardware businesses, such as consumer PCs, laptops, and hard drives.
Financial Highlights, Fiscal Year 2010.
Although the company didn"t reach the $104 billion revenue high point of 2008, they did resume modest revenue growth, reaching almost $100 billion from a 2009 lull of $95.8 billion. The good news is per share earnings and cash flow, which both rose through the three year period as if there were no "glitch" in revenues whatsoever. FY2010 per share earnings rose almost 11.5 percent to $11.52, making 2010 the eighth consecutive year of double-digit EPS growth at the company. IBM"s shift to higher-margin businesses continues to account for the higher earnings in the face of relatively steady sales.
Cash flow continues to excel, with a double-digit increase to $16.01 per share in FY2010. Over the past nine years, Big Blue has generated over $100 billion in free cash flow and has used a significant portion to repurchase shares, retiring some 75 million in 2010 and some 500 million since 2002 to reach today"s 1.2 billion shares outstanding, all while paying a healthy and growing dividend. Improving margins have been part of the IBM success story. Led by the software and services businesses, operating margins have improved from the 1620 percent range through 2008 to 23 percent currently, while net margins have improved from 911 percent to the 13 percent range.
Reasons to Buy.
Once viewed as a teetering giant of the computer industry, with a ma.s.sive intellectual property portfolio but with an uncertain product strategy, IBM has, over the last decade, successfully reinvented itself as a powerhouse in the Software and Services sector. Further, IBM seems positioned "where the puck is going" in the IT world, a fact not lost on HP and other compet.i.tors trying to emulate the business model. Not long ago, many companies felt they had to have in-house information technology departments to service their IT needs. Now, most have found that it"s far more efficient to contract those services out to someone who can provide data warehousing, website development and maintenance, regional/national/global IT infrastructure, etc., without requiring a commitment in fixed a.s.sets. This is where IBM has leveraged their expertise, and as this trend continues and as businesses increase their reliance on these services, IBM benefits. As the common architecture becomes more "cloudlike," we also feel IBM will benefit.
IBM has traditionally led in the development of international IT markets, and today, international business represents about 64 percent of the total. While international has been the fastest growing marketplace for years, U.S. growth recently resumed a positive direction after seven quarters in the red during the recession.
They continue to innovate and are in a great position to acquire whatever technology they choose not to develop internally. They have world-cla.s.s semiconductor design and production facilities and license design, manufacturing, and packaging services and products.
While all IT companies are vulnerable to economic cycles, IBM services income is largely based on long-term contracts, which are not as subject to the vagaries of the world economy as would be sales of hardware.
Finally, the company has an exceptionally strong cash and cash flow position, and has shown the propensity to turn this into shareholder return, both through buybacks and a 15.5 percent annual dividend increase rate for the past ten years.
Reasons for Caution.
IBM has carved out a very large chunk of the outsourced IT business. Innovation in this area can be rapid and disruptive, and margins can shrink precipitously as a result. IBM will have to stay ahead of the curve with innovative and compelling products and defensive product strategies in order to maintain revenue growth.
Compet.i.tion in the services area is heating up, with Hewlett-Packard"s purchase of EDS and Oracle"s acquisition of Sun Microsystems. These two moves have created compet.i.tors with strong synergies and a compelling sales pitch to new and existing customers.
Finally, IBM has a larger exposure to governments and government contracts than many of its compet.i.tors. While this can be stabilizing in hard times, this time we feel that a ma.s.sive and widespread public sector belt tightening could hurt the company.
CONSERVATIVE GROWTH.
Illinois Tool Works.
Ticker symbol: ITW (NYSE) S&P rating: A+ Value Line financial strength rating: A++ Current yield: 2.5%.
Company Profile.
Illinois Tool Works is a longstanding multinational conglomerate involved in the manufacture of a diversified range of industrial products, mainly components, fasteners, and other "ingredients" for other manufacturers. Customers include the automotive, machinery, construction, food and beverage, and general industrial markets. The company currently operates some 850 decentralized business units in fifty-four countries, employing approximately 65,000. Some of the products are branded and familiar, like Wolf and Hobart kitchen equipment and DeVilbiss air power tools; some are obscure and only known to others in the industry.
The businesses are organized into seven major segments, each contributing fairly equally to revenue: Industrial Packaging includes steel, plastic, and paper products used for bundling, shipping, and protecting goods in transit. Primary brands include Acme, Signode, Pabco, and Strapex. Major end markets served are primary metals, general industrial, construction, and food/beverage.
Power Systems and Electronics produces equipment and consumables a.s.sociated with specialty power conversion, metallurgy, and electronics. Their primary products include arc-welding equipment and consumables, solder materials and equipment and services for electronics a.s.sembly. Primary brands include AXA Power, Hobart, Kester, and Weldcraft.
Transportation includes transportation-related components, fasteners, fluids, and polymers, as well as truck remanufacturing and related parts and service. Major end markets are automotive OEM and automotive aftermarket.
Food Equipment produces commercial food equipment and related service, including professional kitchen ovens, refrigeration, mixers, exhaust, and ventilation systems. Major brands include Hobart, Traulsen, Vulcan, and Wolf.
Construction Products concentrates on tools, fasteners, and other products for construction applications. Their major end markets are residential, commercial, and renovation construction.
Polymers and Fluids businesses produce adhesives, sealants, lubrication, and cutting fluids, and hygiene products. Their primary brands include Futura, Kraft, Devcon, and Rocol.
Decorative Services produces a line of countertops, flooring, and laminates primarily for the commercial and retailing markets.
Finally, the remaining ITW brands include a cornucopia of businesses addressing a dozen or more markets. Brands well known to industrial users (and probably not many others) include Chemtronics, Magnaflux, and Texwipe.
Financial Highlights, Fiscal Year 2010.
Mainly because of the economic downturn and an uncertain recovery cycle, we dropped ITW from our 2011 100 Best list. This year, with the economic recovery gaining some steam and the relative health of many U.S. manufacturing sectors including automotive, the company has made the list again.
With exposure across most of the hardest hit industrial sectors, the company fared worse than most in FY2009, experiencing a 13 percent drop in revenues and a 37 percent skid in earnings per share. But the company gained almost all of that back in FY2010, with a 14 percent increase in sales to $15.9 billion and a recovery in earnings per share to near parity with FY2008. Without the effects of an FY2009 tax adjustment, "organic" earnings for FY2010 Q4 were actually 30 percent ahead of the prior year.
For FY11 the prospects of continued recovery bode well, and ITW expects a healthy 10 percent revenue gain to $17.4 billion with per share earnings in the $3.60$3.84 range. The businesses are doing well and generating solid positive cash flow, which is being used to repurchase shares. The company has retired some 127 million of 617 million shares since 2003, and raised its dividend to an effective $1.36 per share annually.
Reasons to Buy.
Buying shares of ITW is like buying a mutual fund covering the entire U.S. and world manufacturing sector. The company is well diversified and serves many markets, some with end products, some with components, some in cyclical industries like automotive and construction, some in "steady-state" industries like food processing and packaging. We should note that foreign sales accounted for 57 percent of the totala healthy figure for an industrial goods company. The company has solid models for making acquisitions, and seems to do better than most conglomerates historically in choosing candidates and then managing them once they"re in the fold. The company seems to do an equally good job of turning opportunity into cash flow and using that cash flow to enhance shareholder returns, as exemplified by the steady record of dividend increases each year since 1994.
Reasons for Caution.
ITW is by nature tied to some of the more volatile elements of the business cycle, and so may not be the best pick for investors living in fear of the next downturn. Conglomerates are notoriously difficult to manage (it"s hard enough to manage one business, let alone 850 of them); any sign of cracks in this structure should be taken seriously. While acquisitions are part of the growth strategy, the company, thus far, keeps them small and does not depend on acquiring other big names, but the disruptions of a big acquisition could pose problems.