Resideo: Honeywell’s Boring, No-Growth Spin-off Might Manage to Actually Grow EPS for 3-5 Years
Yesterday, Honeywell set the distribution date for the spin-off of its home comfort and security business “Resideo”. So, I thought now would be a good time to do an “initial interest post” on Resideo. In this article, I’ll give my first impressions of the stock and then I’ll conclude by giving you an idea of how interested I am in following up with this stock idea. As always, I’ll grade the idea on a scale ranging from of 0% interest to 100% interest.
To give you some context, let’s start with a review of how interested I was in the five other stocks I looked at.
Keweenaw Land Association (KEWL): 90% initial interest level
Pendrell: 90%
Maui Land & Pineapple (MLP): 80%
U.S. Lime & Minerals (USLM): 50%
Babcock & Wilcox Enterprises (BW): 10%
The details for the ratio of shares of Resideo to Honeywell (1-for-6), record date (October 16th), and distribution date (October 29th) can be found here:
https://www.sec.gov/Archives/edgar/data/773840/000119312518290912/d528228dex992.htm
The notes I took when reading the Resideo spin-off document can be found here:
Resideo includes a products business (“Honeywell Home” or “Products”) and a distribution business (“ADI global distribution” or “Distribution”). Resideo will operate in multiple countries. And it will spin off with about $1.23 billion of debt from Honeywell and liabilities related to over 200 environmental clean-up sites. We’re interested in valuing the stock (the equity portion, not the debt). So, it’s easy to get lost in the complexities of this situation. The first thing we need to do, then, is to focus on those aspects of this spin-off that could drive returns in the stock. In other words, we need to start simplifying things right from the start.
Here are some of the first questions we need to ask:
How much debt will Resideo have when it spins off?
How big will Resideo’s environmental liabilities be when it spins off?
How expensive will the stock be when it spins off?
Where will most of Resideo’s “owner earnings” (“free cash flow”) come from?
Let’s start with the last question first. In recent years, Resideo has gotten about 75-80% of its profits from the “products” business rather than the distribution business. There’s a lot of information in the spin-off document – and therefore, in my notes – about ADI. However, ADI only accounts for about one-fifth of profits (about half of revenue) at Resideo. It’s easy to get sidetracked by spending as much time on ADI as we would on Honeywell Home (“products”). On a sales basis, the two businesses are equal in size. But, sales aren’t what matters to a shareholder. Profits are what matters. Gross margins at Honeywell Home (the products business) are about 4 times higher than gross profits at ADI (the distribution business). Therefore, the same amount of sales at each business translates into roughly 4 times more profit (80% of profits versus 20% of profits) at Honeywell Home.
In this initial interest post, I really want to set ADI aside and focus on the main profit driver here which is the products business. That’s difficult to do. I honestly feel I understand the distribution business better than the products business. For example, I invested in a company – George Risk (RSKIA) – that supplied its products largely through ADI (30-40% of its sales were made to ADI in many years). Nonetheless, we need to focus on what matters most – not just what we can understand best. In this case, Honeywell Home is what matters most. It is 3-4 times more important to Resideo shareholders than ADI is. So, for now, let’s chuck ADI aside and turn our focus entirely to Honeywell Home.
Next, we have the question of domestic sales versus foreign sales. About two-thirds of sales are made in the U.S. The company provides several breakdowns by geography at various points in the spin-off document. But, the simplest rule of thumb to follow here is that probably no less than 2 out of every 3 dollars of profit at Resideo comes from the U.S.
This means the single biggest determinant of Resideo’s profits is sales of Honeywell Home products inside the United States. The domestic products business probably makes up about half of Resideo’s value as a stock. So, when we think about the competitive situation this company is facing – we should start by looking at products and the United States.
What kind of products does Resideo make? Who does Resideo make them for? Who are they sold to? And who eventually uses them?
Let’s start with the last question first. Resideo’s Honeywell Home products in the U.S. are primarily used by American homeowners.
What products does Honeywell make?
Honeywell Home makes products like: security panels, security cameras, sound detection, thermostats, whole house humidifiers and de-humidifiers, water filters, furnace and boiler controls, freeze detectors, leak detectors, etc. The company’s oldest product category is thermostats. It has relationships with original equipment manufacturers like ADT (security), Carrier (air conditioners), and A.O. Smith (water heaters). Honeywell Home is bigger in “comfort” than it is in security. So, we’ve now moved on to “who” Honeywell makes these products for. The company makes these products for home security companies, HVAC companies, etc.
The decision makers are professionals. Most of the Honeywell products going into U.S. homes are not being bought by homeowners. They are instead being bought by companies like ADT, Carrier, and A.O. Smith and then incorporated into their products. Or, they are products that are being installed by professional contractors of some sort. Honeywell does make some products – including some “connected” products – that homeowners can buy themselves and install (“do-it-yourself”). Again, I think this is a tangent an investor could get distracted by. It’s easy to think that whatever Honeywell product you see being sold at Best Buy is the key to this company’s success or failure. In reality, do-it-yourself sales of products through a retailer like Best Buy are not driving a big portion of this company’s profits. That’s not the sales channel this company is focused on. It’s just the channel that is most conspicuous for you as a homeowner.
Where is Honeywell making these products?
Here, we get to one of the risk factors. Honeywell manufactures products for the U.S. market in Mexico (as well as in the U.S. itself). A change in the North American Free Trade Agreement (NAFTA) that disadvantages Mexican imports of these products into the U.S. relative to how they are treated now would be bad for Honeywell. Generally, Honeywell does not produce a lot of products in categories where you manufacture on the other side of the world and then ship the products in to the market you want to sell in. For example, Honeywell has manufacturing in Scotland, the Netherlands, and Mexico. It does not have any manufacturing in the Far East. Those kinds of manufacturing locations are typical for a company that needs to be close to customers in the U.K., E.U., and U.S. You see this kind of manufacturing set up a lot with things that go into new homes, renovated homes, etc. Products may be sourced across the border. But, they’re usually not sourced from the other continents.
We could spend time talking about the Honeywell brand, its patents, etc. But, I think that stuff is self-explanatory. Honeywell has been involved in home comfort such as climate control for over 100 years. It’s been one of the best known names in that area for just as long. The brand is as good, well-known, etc. as anything in that space. It has long made stuff in that product category for some of the best known equipment manufacturers in each of the areas of home comfort and security. Do we have enough information to determine it’s a wide moat business? Probably not. Does it seem to have as good, as long, and as durable a position in this industry as anyone else in the U.S.? Yes.
What are the economics of this business like?
They’re good. Gross margins are high. Resideo has about 50% gross margins in its product business. Net tangible assets are low. So, the after-tax returns on equity – and this is without leverage, Resideo will actually be leveraged when it spins off – are excellent. Again, I don’t think it’s worth carefully quantifying this. If you find a business you’re sure will earn better than 30% after-tax returns on tangible owner’s equity – it’s not really worth arguing about whether it’s 30% or 60%. Instead, you should focus on the prospects for re-investment. Remember, you’re not going to be sold this business at book value. So, even if it is earning 30%+ returns on equity – if you’re paying several times book value and then the company doesn’t grow, how are you benefiting from these really high returns?
I don’t see good signs that Resideo can grow a lot. I did some quick checks of the size of Honeywell’s Home business 20 years ago, I checked the size of George Risk 20 years ago, I looked at the size of ADI 20 years ago. These things haven’t really grown much. They’re very stagnant. And that’s not a huge surprise. One, we’re cyclically at a not very high point in the housing market. Two, the U.S. population growth between 1998 and 2018 hasn’t been very high. Household formation hasn’t been that high. It’s a slow growth country that way. And then the U.S. already had very high penetration rates for some of these technologies 20 years ago. A lot of people already had water heaters, central air, central heating, humidifiers, de-humidifiers, etc. who needed those things. When you compare certain residential and commercial climate stuff in the U.S. to Europe, Asia, etc. the U.S. seems very well along in those things. It’s one of the most developed markets for this stuff. In fact, it may literally be the very most developed market of all. Finally, some of these things can be deflationary in terms of costs. There are some signs of that – especially earlier in the 20-year period I looked at – so, a company may not have been making much more in sales but this did not stop profits from being just as high. I think the real unit costs of some of these things declined. But, I don’t have enough information on that. There are definitely economies of scale in matching large parts suppliers with large original equipment manufacturers and things like that. Shifting manufacturing from the U.S. to Mexico may have reduced costs too. Overall, I would rate this as a “no REAL growth” business long-term. However, it will grow cyclically. I think Resideo’s product sales could be as much as 20% higher in the future than they are today. This is due to where we are in the housing cycle. The normal level is probably 20% higher than today’s level. And, like any cycle, the U.S. housing cycle will overshoot normal at some point.
Now, let’s get down to price.
Honeywell stock isn’t cheap. We have no reason to believe this spin-off will be done at an especially low price. Resideo stock might trade down over time if Honeywell’s shareholders sell it off. They aren’t opting in to this spin-off. And no Honeywell shareholder bought that stock to get this business. The spin-off is quite small compared to the overall size of Honeywell. It’s worth watching the stock in the say 1 month to 1 year period following this spin-off to see if there’s indiscriminate selling of Resideo.
Debt will be about $1.25 billion. That’s a manageable debt load for this company. The 3-year average operating profit from Honeywell Home was about $380 million. Debt isn’t much more than 3 times the EBITDA of this unit alone. And there’s profit from the distribution business too (which adds at least another $100 million). We don’t have cash flow data. But, based on some information about expected cap-ex, the balance sheets for past years, etc. I can tell this is a very cash flow generative business. Also, there are two somewhat separate businesses here. That diversifies earnings available to cover debt payments a little. I don’t see the debt alone as an insurmountable burden. However, I do expect investors will take this $1.25 billion parting gift from Resideo to Honeywell into account. Investors are usually pretty knowledgeable about how to calculate enterprise value and adjust a stock’s price for its debt level. Spin-offs with a lot of debt are common. Investors who focus on spin-offs know to look for this.
What might they not know to look for though?
Well…
The $140 million a year environmental liability payment is the interesting part. So, Resideo is doing a deal with Honeywell where it will be responsible for paying Honeywell up to $140 million a year. This amount is capped. It can, however, decline over time if the annual environmental payments Honeywell makes on some 200+ clean-up sites declines. Also, it’s important to note that Resideo can NOT deduct this $140 million payment for income tax purposes. Therefore, the potential improvement in Resideo’s future earnings from that $140 million declining to $0 at some point is equivalent to more like $180 million in added EBIT. This is because you’d usually need to earn about $180 million more before taxes in the U.S. to keep another $140 million in free cash flow. And that’s a conservative assumption. For most companies, $180 million in added EBIT would – through a combination of taxes and non-cash forms of earnings – end up producing less than $140 million in free cash flow. Here, this is a pure after-tax cash outlay. The company is just giving Honeywell $140 million a year in actual cash. That amount can never go up. But, it can go down. I know environmental clean-up sites don’t sound like a benefit. But, here, the presence of those sites and the Honeywell agreement could be an advantage for investors who are focusing in on Resideo and trying to model earnings out.
I’m not going to value Resideo yet. This is an initial interest post. But, if I did value the company – I’d do it over a 5-year period. I’d model out these things:
- Projected earnings of Honeywell Home in 2023
- Projected earnings of ADI distribution in 2023
- Projected cash outflow for environmental liabilities in 2023
- Remaining net debt balance in 2023
And then I’d simply put a multiple on Resideo’s FCF.
Resideo might grow earnings faster than you think here. For example, if the housing cycle is at or above its long-term trend in 5 years, this could add 3-4% a year to earnings over the next 4 years. Inflation could add 2-3% a year to earnings over the next 4 years. And then, if environmental payments halved over the next 5 years – you’d get another 3% a year increase in EPS.
The company will also be leveraged in terms of debt. EV/EBITDA takes that into account. But, P/E doesn’t. It’s easy to imagine – a year from now – that some investors look at this business trading at a low teens P/E or something and think it’s not cheap because that’s a normal P/E for a no growth business.
However, we know a few things about the business. One, it can grow due to the housing cycle improving. Two, it might – this is very speculative – be able to grow due to inflation. Three, it might – this is even more speculative – be able to grow due to declining environmental payments.
I can imagine this company growing EPS by up to 10% a year over the next 5 years. I can’t say it will. Because, I can also imagining EPS growing closer to 3% a year. But, the important thing to keep in mind, is that I can see Resideo being in a “no-growth” industry and yet still growing EPS by a percentage – just for the next 5 years, not beyond that – of really high single digits.
That’s interesting because we know cash needs here are low. So, assume the company pays a dividend (it says it plans to). Or, assume the company buys back stock (it might). Add that on to your expected annual growth rate in company-wide free cash flow.
There are a lot of ways where if this company spins off at a “no-growth” type P/E ratio – and that’s a big if – I could see a path of 10-20% annual returns over the next 3-5 years. A lot of this has to do with things – capital allocation, the housing cycle, and environmental liabilities – that I don’t have predictions about.
But, at the right price, things could be shifted into your favor here.
I’ll be curious to see what kind of multiple this spins off at. I’ll watch it from time-to-time in the first month to year of trading.
At first glance: the competitive position and the financial position here seem sufficient for me to not immediately cross Resideo off my watch list.
It all depends on the price it spins off at and the earnings model you come up with for the next 3-5 years.
I’m interested. But, till I see a price on this one – I’m only slightly interested.
Geoff’s initial interest level: 30%