Thursday, December 27, 2012

Pall Corp's Prospects

I always like looking at companies with diversified end markets because they tend to give valuable information on their individual verticals. In the case of filtration company Pall Corp (NYSE: PLL), it really is a tale of two cities with some differences within the suburbs too. The Industrial city’s prospects got worse over the quarter while the Life Sciences metropolis is actually doing quite well. No matter; it wasn’t enough to stop sales declining .1% in the quarter, and forecasts for next year were taken down.  I last discussed the company in an article linked here and argued that the stock needed to come off a little bit. It has, so it’s time to ask whether Pall is good value right now.

The Case for Pall Corp

Pall is a nicely balanced business comprised of Life Science and Industrial segments, which complement each other.  It typically operates a razor-blade model comprised of system and consumables sales. The good news is that end demand is partly driven by environmental and regulatory concerns, but the bad news is that consumables demand is driven by activity. Less activity, less sales.

Industrials Suffering

Unfortunately, it’s been a tough time recently for industrial cyclicals. Growth is slowing on a global basis, but interestingly it is the growth in global trade that seems to be bearing the brunt of the slowdown. I first heard this point made on FedEx’s (NYSE: FDX) conference call and in retrospect it was a good read on what was to come in earnings season. FedEx warned that global trade was slowing faster than global GDP growth as a consequence of increasing protectionism and faltering western demand causing a slowdown in Far Eastern exports.

All of which has played out in slowing microelectronics and semiconductor demand, and it shows in Pall’s results. Frankly, I wouldn’t assume a turning point in consumer electronics until a major bellwether like Intel (NASDAQ: INTC) comes out and starts talking about things like gross margins increasing again. As it stands, Intel and everyone else in the industry have been lowering expectations, and it is results like these from Pall that cause more concerns.

A look at sales and orders by segment.

Industrial growth slowed over the quarter with emerging markets being weaker than expected. On the conference call, Pall explained that 2/3 of the slowdown is due to the end market and 1/3 due to customer de-stocking, although frankly these elements are driven by similar factors. Customers de-stock when they feel less confident about the outlook. Municipal water customers are predicted to be weaker in 2013, and I think there will be downside surprise in aerospace.  For example, when a bellwether like General Electric (NYSE: GE) gives disappointing results and sees order books declining in its aviation and energy segments, then the industrial sector is definitely weaker.  GE’s shorter business cycles have been weak, but when this starts to feed through into the longer cycle then it is a sure sign that times are tough.

However, there was some good news. Operational efficiencies actually caused margins to increase and segmental profits rose to $52.8 million from $43.6 million last year. Impressive stuff.

Life Sciences Firm

Paradoxically, segment profits at Life Sciences fell to $69.8 million vs. $79.7 million last year. Go figure!

The reason for this was an unfavorable sales mix, which should hopefully resolve itself in future quarters. Gross margins should rise in the future, particularly as there is good momentum in the biopharma (67.5% of LS sales) business. Bizarrely, Pall reported some decent conditions in life sciences in Europe amidst claiming to be taking market share.

Life sciences remains the big hope for Pall in 2013, and the numbers suggest that the pharmaceutical industry is still investing in order to get over its very own cliff.

Where Next for Pall Corp?

Investors will be hoping for more operational efficiencies in the industrial segment plus the usual canard of Chinese stimulus spending to drive a second half pick up. Moreover, Pall has been stripping out low margin system sales, and there is more room to run here, so margins might continue to improve even as revenues fall.

Guidance is for flat to low single digit growth in overall revenues with EPS growth of 5-13%. This represents a reduction from the 9-16% earnings growth previously forecast. The stock is not particularly cheap on a cash flow or EV/EBITDA basis (12.7x) and is probably only worth considering if you think you are buying it at close to the bottom of the industrial cycle. Frankly, I think the evidence is that conditions will get worse near term, so cautious investors might want to hold fire and monitor events.

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