The activist firm Elliott Investment Management has written to Honeywell International's (HON -1.01%) board of directors arguing for the conglomerate's breakup. The move follows a period of disappointing performance for the stock over the last few years: It's up only 4.8% over the previous three years compared to a 27% increase in the S&P 500 index.
Is Elliott's move a catalyst to buy the stock?
Time to break up, Honeywell?
Elliott's central argument is that Honeywell's conglomerate structure is no longer suitable, and separating the company into two new companies focused on aerospace and automation is in the best interests of shareholders. In the letter, which was made public, the investment firm makes two key arguments in support of this case.
First, it cites Honeywell's valuation discount to its peers and points out value-creating breakups initiated by Honeywell's peers.
Second, it notes the underperformance by the former safety & productivity solutions (SPS) businesses -- which include warehouse and workflow improvements, productivity solutions, and personal protective equipment (PPE) -- "all of which have declined at a double-digit rate since 2021." Elliott believes "Honeywell's conglomerate model has contributed to this underperformance."
The first argument is powerful. The second one is more questionable and, as such, casts some doubt on the case for a breakup, at least from a timing perspective.
The next industrial conglomerate to break up
Honeywell's two key peers, General Electric and United Technologies, have broken up or been absorbed into other companies and added value for shareholders.
The idea is simple: Breaking up allows management to focus attention and resources on specific businesses while allowing for a capital structure that suits the profile of the individual businesses. Reducing complexity is the aim from an operational perspective. And from an investment perspective, there's an opportunity for a valuation expansion.
As you can see below, and as previously argued, Honeywell tends to trade toward the bottom of a group of its competitors (as cited in its Securities and Exchange Commission filings) across its various industries. The idea is that having these businesses trade separately as aerospace and automation companies will lead to a valuation expansion across both companies and unlock shareholder value.
Data by YCharts. EV = enterprise value; EBITDA = earnings before interest, taxes, depreciation, and amortization.
Also, operating as separate companies will lead to margin expansion because the businesses will be better run and have easier access to capital due to higher credit ratings. As such, Elliott's first argument carries weight.
Some flaws in the argument
Still, the second argument has flaws. Elliott notes that the SPS businesses have declined significantly in recent years. But some context is needed, and it's far from clear that their decline is related to the conglomerate structure. In recent years, all three businesses have dealt with difficult cyclical conditions.
The PPE business understandably surged during the pandemic lockdowns, and as those conditions eased, it faced extremely challenging comparisons.
It's a similar story at warehouse and workflow solutions (primarily e-commerce warehouse automation), whereby capital spending on e-fulfillment boomed during the lockdowns only to severely correct naturally since customers had already built out capacity.
Lastly, in productivity solutions and services, direct competitors like Zebra Technologies also suffered severe sales contractions as the retail and logistics sectors pulled back on investment due to the slowdown in the economy and the previous boom in e-commerce logistics discussed above.
These issues are largely cyclical and end-market related. Indeed, the Elliott letter notes, "idiosyncratic events in Warehouse, Productivity and PPE drove significant historical declines, but have begun to stabilize." As such, if Honeywell can return them to growth, the market might look more favorably on the stock. And Honeywell is reported to be willing to sell its PPE business.
Another flaw in Elliott's argument comes from the assumption that the market will value the new "Honeywell Automation" business in line with its automation peers. Under Elliott's plan, it would house the disparate industrial automation (including the SPS businesses) and building automation businesses, as well as Universal Oil Products (UOP), which sells catalysts and absorbents to petrochemical and refining customers.
Is Honeywell a stock to buy?
Management's restructuring of Honeywell into four segments is already a step toward making a breakup possible, not least because it separates the industrial automation and building automation businesses (Elliott's plan puts them in one company). An alternative plan would involve an opportunistic and piecemeal approach to divesting or spinning off businesses at the right time.
Image source: Getty Images.
Management already plans to spin off its advanced materials business in 2025 and sell its PPE division. A recovery in the SPS sector would support separating industrial automation, especially with potential growth in process solutions. The building automation sector is strong enough to stand alone, and it's questionable if industrial automation and building automation belong in the same business, let alone with UOP.
Gradually divesting businesses while retaining a core aerospace division seems a sensible strategy, similar to General Electric's approach under CEO Larry Culp.
Elliott's case makes a strong argument for Honeywell's stock value, but the company's challenges are not just due to its conglomerate structure. It may be better to let management implement its current plans instead of rushing to break up the company. As such, Honeywell remains an attractive option for value investors, especially if management is considering such proposals.
