Software Companies Are Hot. Now Honeywell Wants to Be One.
Barron's
May 15, 2019
Industrial companies aren’t just industrial companies anymore.
They are trying to sell more software to boost profit margins and reduce their reliance on the business cycle, a shift Honeywell International highlighted Tuesday when it told investors about its transformation into what it called a “software-industrial” company.
An investor event the company hosted offered few surprises—management affirmed earnings forecasts given a few weeks ago—leaving investors time to think about the strategic direction of the industrial giant.
And Honeywell (ticker: HON) is big. With a market value, including debt, north of $128 billion, it is one of the largest industrial enterprises in the world. It makes chemical products, aircraft parts, and refrigerant for air-conditioning, as well as a host of other things.
Management wants Honeywell to sell more software, hoping the shift will improve its competitive position in the marketplace and boost profit margins. That would further a transformation effort that was already under way in 2018, when Honeywell spun outResideo Technologies (REZI), a maker of security systems, and Garrett Motion (GTX), which produces turbochargers.
During the next phase of Honeywell’s overhaul, CEO Darius Adamczyk expects enhanced growth from its existing businesses, higher margins, and “transformation into a software-industrial” company.
Honeywell is already selling lots of software. Management said Tuesday software sales last year totaled about $3 billion, or 8% of estimated 2019 sales. Their goal is to expand the software business at 20% a year for the foreseeable future.
Que Thanh Dallara, president of Honeywell’s Connected Enterprise unit, said about half of Honeywell’s software sales, or $1.5 billion, came through that unit, while the rest was within other business groups.
“This is a software that is very inextricably linked to the hardware solutions that we provide,” she told the crowd.
The Connected Enterprise software Dallara spoke about is the kind found everywhere, embedded in all sorts of hardware. Software built into hardware, such as a washing machine, isn’t going to transform any company’s margins.
Still, embedded software can get smarter and connect devices to the cloud, enabling different business models in an Internet-of-Things world. Industrial companies with better data and machine learning can sell preventive maintenance or performance-optimization solutions. That’s part of the software transformation going on at many industrial companies, including Honeywell.
The other $1.5 billion in software sales Dallara talked about is what investors think of when they think of software. It’s the business model where people pay a license fee or a subscription to access a program that gets updated every year or so.
That software is a high-margin business. The average gross margin for software companies in the S&P 500 is about 71%. Industrial gross margins are about 26%.
“We believe that one of the underlying messages is that Honeywell is capably transforming Honeywell’s software emphasis organically, as opposed to needing some epic acquisition to reshape the company,” wrote RBC Capital Markets analyst Deane Dray. He believes the software business has achieved critical mass and can grow without management bolstering it via deals.
“We continue to like the company’s strong balance sheet and de-risked pension plan at this point in the cycle,” Dray wrote. “We also like the prospects for an eventual further positive rerating.”
Rerating means a stock gets a higher, or lower, valuation than in the past because investors recognize the business has changed. Honeywell trades for about 21 times estimated 2019 earnings, above its historical average, but only a little higher than other large aerospace companies. Dray rates Honeywell shares Outperform with a $175 price target.
Software is the future, but today’s reality is wrapped up in the Chinese-American trade war and a slowing global economy.
“Near term, Honeywell remains still somewhat cautious toward the global macro short-cycle economy, particularly in the wake of the recent step-up in trade friction with China,” Gordon Haskett analyst John Inchsaid in a recent research report. “None of Honeywell’s businesses believe that China trade tensions are likely to lead to incrementally increased [direct] sales pressures.”
That’s good news for Honeywell investors. And if trade tensions subside, investors can get back to worrying about something else. Like how Honeywell hopes to dominate its industrial competition with software sales.
Honeywell stock closed up 0.8% Tuesday at $168.16, in line with the gain in the Dow Jones Industrial Average. It was marginally higher on Wednesday as the Dow slipped.