Wednesday, October 31, 2012

Pall Corp Earnings Analysis

Filtration company Pall Corp (NYSE: PLL) gave full year results recently and confirmed why it appears to be the kind of stock that long term investors should favor. Its long term revenue drivers are guided by regulatory and environmental quality concerns and it combines a cyclical division (industrial) with a more defensive division (life sciences). This gives it the opportunity to grow across the economic cycle.

Pall operates the kind of razor-blade model that ensures long term consumables revenue growth provided it can get its systems sold into to its end markets. It is an attractive company and the market knows it. The question is do its prospects justify its valuation?



Pall Corp’s Results

Management described its fourth quarter as being ‘solid’. While this word implies stability, the underlying picture was actually quite varied on a regional and industry basis. For example the Americas saw strong growth while Europe and Asia were flat. On an industry basis biopharmaceuticals, aerospace and machinery & equipment all did well while industrial markets in Europe saw notable weakness.

As discussed above, when the economy is weak we can expect system sales to slow, but consumables should carry on generating growth and cash flow. Indeed, consumables now make up 85% of total revenue and aside from industrials in Europe (consumables orders fell 7%) there was strength all round.

The breakdown of divisional systems and consumable sales were as follows.




I want to look into more detail within the divisions.

Life Sciences

Life science consumables sales rose 13.7% while system sales declined 30.5%. Before anyone panics over the latter number, let’s recall that Pall made a conscious decision to cut back on unprofitable life science system sales. In particular it rationalized system sales in its Food & Beverage segment in the parts of the business where it doesn’t have the razor-blade model.

In addition part of its restructuring program involved selling its blood transfusion filtration operations to Haemonetics (NYSE: HAE). This deal makes sense for both parties. Pall gets to refocus on life sciences companies and away from selling to blood centers while Haemonetics will be able to further increase its penetration of the whole blood collection market.

Delving deeper into the numbers shows that biopharmaceuticals sales increased 19.8%, food and beverage increased 4.5% and medical was up 1.6%. As alluded to earlier, this division is relatively defensive and gives Pall good long term visibility of earnings and cash flows.

Going forward margins can be expected to improve as lower profitability sales are being rationalized and ongoing strength in biotech industry investment should ensure decent growth going forward for life sciences.



Industrial

In Q4 consumables sales rose by 4.6% and system sales went up 7.3%. This rather impressive headline performance masks some dramatic differences in performance. Aerospace sales went up 21.6% while process technologies declined -.2% and microelectronics went up a paltry 2.2%.

The differences within the components of the industrial segment correlate nicely with what is happening in the global economy. Microelectronics can be expected to be weak going forward because the semiconductor cycle simple hasn’t picked up again as most commentators had hoped it would. Indeed, the Semiconductor Industry Association has been lowering chip sales forecast throughout the year and the recent trading statement from Intel (NASDAQ: INTC) revealed weakness in pretty much all areas of its business.

Incidentally, I think a company like Pall can provide very good forward indications of Intel’s future growth and I would encourage investors to look out for its commentary on the issue. Intel’s recent reduction in sales forecast is not good news.

As for aerospace, we only have to look at Boeing’s (NYSE: BA) order book to see how strong commercial is at the moment. However, I confess I have some concerns going forward. A lot of aerospace demand is coming from emerging markets and in a slowdown orders will get canceled or delayed. Airlines go bust and passenger miles see growth slowing. Boeing’s order book may not be as secure as many think.



Where Next For Pall Corp?

While being an attractive business, investors should remember that they are always buying the price of the business rather than making a value judgement based on how much they like it. Pall doesn’t look especially cheap right now. Its life science business will probably do well next year but I have some concerns about the more cyclical industrial division. Semiconductors will be weak at the start of the year and I have concerns over aerospace.

In terms of evaluation, the stock does deserve a premium. Consumables sales are growing strongly and they tend to be more cash generative which means that a discounted cash flow analysis should see free cash flow generation increasing in the future.

The argument could be made that it will be a beneficiary if any cyclical upturn occurs but a quick look across at a comparable company like 3M (NYSE: MMM) (which also competes with Pall) shows it on a current PE of 15 and a forward forecast of 13.3x for 2013. Both companies have similar end market drivers in the industrial space but 3M is far cheaper and boasts a 2.6% yield.

For next year Pall is guiding towards 9-16% EPS growth which, if achieved, would leave the stock on no more than a fair valuation in my opinion. I’m uncomfortable buying a stock on a forward PE of 20 when I have some concerns over its ability to even hit that elevated ratio. There is little margin of safety here.