Is This Dip a Buying Opportunity for Pall Corporation?

On Feb. 20, Pall Corporation (PLL, Financial) shares hit a new high. But just four days later, the company lowered its guidance, and the share price began falling.

It wasn’t that the company expected its earnings to fall, but rather it expected the rate of growth to slow. It estimated its earnings for fiscal 2015 (ending on July 31) would grow by only 6% to 12%. Nevertheless, as the following chart of the share price shows, that led to a loss of confidence that continues:

Does this dip represent a buying opportunity, or is it a harbinger of more trouble ahead?

History

1946: Using experience and knowledge gained while working on the Manhattan Project in World War II, David B. Pall founds the Micro Metallic Corporation.

1957: Renamed Pall Corporation.

1958: Pall begins developing aircraft hydraulics filters, and follows up with filters to purify jet fuel.

1966: Pall Europe Limited established.

1970: Plays a major role in cleaning up the Three Mile Island nuclear accident.

2000: The company begins paying a dividend ($0.165 - most recent dividend = $0.305).

2009: Newsweek names it one of the greenest companies in America, in its Green Rankings.

2011: Receives the Engineering Materials Achievement Award (EMAA) from ASM International.

2013: Acquired ATMI LifeSciences business for $185 million.

History based on information at Wikipedia and FundingUniverse, and a company news release.

Comments: An early tech company, emerging just after World War II; international expansion begins in the mid-1960s; an active buyer of other companies, only one of which is shown here.

Pall Corporation’s Business

Pall is generally known as a filtration company, but in its 10-K it describes itself as, “...a leading supplier of filtration, separation and purification technologies.”

It goes on to say, “Our products are used to remove solid, liquid and gaseous contaminants from a variety of liquids and gases...” and it adds its products are, “principally made by us, using our engineering capability, fluid management expertise, proprietary filter media and manufacturing expertise.”

It operates through two reporting segments:

• Life Sciences: develops, manufactures, and sells products to customers in the BioPharmaceutical, Food & Beverage, and Medical markets.
• Industrial: develops, manufactures, and sells products to customers in the Process Technologies, Aerospace, and Microelectronics markets.

Products, too, are divided into two categories:

• Consumables: mainly filters made with its own proprietary filter media. They provided 88% of sales in fiscal 2014.
• Systems: described as larger capital goods, which, when completed, usually provide an ongoing revenue stream for consumables. They provided 12% of sales in fiscal 2014.

Pall sells around the world, which it divides into three regions for operating purposes: the Americas, Europe (including the Middle East and Africa), and Asia.

Competition

The company reports intense competition in all its markets, from other big businesses and from smaller regional competitors.

To some extent, its main competition comes from older technologies, where lesser requirements allow entry by numerous other firms.

Where Pall has a moat is in processes that require what it calls, “stringent product performance standards, product qualification protocols and requirements for consistent levels of global service and support.”

Turning to competition in specific product areas, the company lists it major competitors as:

• BioPharmaceuticals: includes Merck Millipores (a division of Merck KGaA), The Sartorius Group and GE Healthcare (a unit of General Electric Company (“GE”)
• Food & Beverage: includes 3M Purification, Pentair, Inc. (PNR, Financial), Filtrox Group, The Sartorius Group, Eaton Corporation and Parker Domnick Hunter (a division of Parker Hannifin)
• Medical: includes Merck Millipore, GE Healthcare, Teleflex Incorporated (TFX, Financial), Covidien plc and Intersurgical, Ltd.
• Process Technologies: includes CLARCOR Inc., Donaldson Company, Inc. (DCI, Financial), Parker Hannifin Corporation (PH, Financial), HYDAC International GmbH, GE Infrastructure (a unit of GE), Pentair, Inc., 3M Purification, U.S. Filter (a unit of Siemens AG) and ESCO Technologies Inc.
• Aerospace: includes Donaldson Company, Inc. (DCI), and ESCO Technologies Inc.(ESE, Financial)
• Microelectronics: includes Entegris, Inc., Parker Hannifin Corporation (PH) and Mott Corporation.

This illustration from a presentation to the J.P. Morgan Healthcare Conference on January 13, 2015 optimistically sums up its take on the competitive environment:

Pall spent $102.6 million on research and development in fiscal 2014.

Other

Incorporated in New York State, and headquartered in Port Washington, NY.

At the end of fiscal 2014, Pall employed 10,400 around the world. Some of those employees are represented by unions or worker councils, but the company says its labor relations are generally good.

Fiscal years end on July 31.

Industry/Sector: Industrial Products » Diversified Industrials.

Unless otherwise noted, information in this section (and other sections) is based on the 10-K report for fiscal 2014.

Comments: Pall Corporation, with nearly $3 billion in sales for fiscal 2014, competes against some of the world’s biggest industrial names. However, with its focus on filtration, separation, and purification, backed by a significant research budget, and the strength of ongoing consumable sales, it does have a solid niche.

Opportunities, Risks, & Growth

Opportunities

The biopharm single-use technology market is growing rapidly; last year, Pall bought ATMI Life Sciences as part of its strategy to capitalize on that growth.

R & D is growing the pipeline of new products, which should open new doors and wider doors; last fiscal year, Pall turned out 274 invention disclosures and 57 original patent applications.

This includes the development of new core materials. In its Annual Report for 2014, it says, “The company’s growing library of core materials is a competitive advantage."

Pall has extensive expertise in finding, acquiring, and integrating firms that can extend or deepen its penetration into growing markets.

It boasts a large international footprint, allowing it to tap into the world’s biggest growth markets for both systems and consumables.

Risks

That international footprint brings with it several risks, as well. It could be affected by currency exchange rates, unfriendly legislation or regulation in other countries, and political turmoil.

As a technology company, it depends on its ability to continuously develop new products, and to get them through the distribution channels. Competitors are all doing the same, and failure to keep up could adversely affect both short-and long-term prospects.

At the same time, products that fail to work properly may expose the company to costly liability claims, increased regulatory oversight, and other issues that materially affect the company.

The global economic climate affects the company; for example, 40% of 2014’s sales came from Europe, so the region’s current economic uncertainty could reduce demand for Pall products, or push down margins.

If supplies of some raw materials are stopped or constrained, its ability to manufacture would be negatively affected.

Growth

Here’s a snapshot of Pall Corporation’s growth since the 1990s, and a projection through until 2018 (in the yellow band). Revenue is on the green line and EPS (Earnings Per Share) is on the blue line:

The analysts followed by Yahoo! Finance, expect, on average EPS of $3.73 for fiscal 2015 and $4.16 for fiscal 2016, both up from the $3.25 for fiscal 2014 (which ended July 31, 2014).

Pall has specific plans for maintaining its growth, including:

• Improved customer service metrics such as on-time delivery and reducing defective parts per million.
• Reducing costs by improved controls. consolidating its footprint, and eliminating waste from the supply chain.
• Improving capital efficiency, through “...a rigorous process of capital project review with clear requirements for return on investment.” (2014 Annual Report)
• Growing internal talent with a core curriculum of key leadership training, sales and project management training courses; more than 1,400 managers trained in fiscal 2014.

Comments: Based on the chart and financial results, the company has made the most of its opportunities, and minimized its risks, to deliver strong growth since 2008.

Management

Chairman, President, and Chief Executive Officer: Lawrence D. Kingsley, age 51; CEO since 2011 and Chairman since 2013. Previously Chairman and Chief Executive Officer of IDEX Corporation (IDEX), which produces fluid and metering technologies and health and science technologies products.

Interim Chief Financial Officer: R. Brent Jones: Mr. Jones is the third CFO in two years; Lisa McDermott left in 2013, and her successor left at the end of 2014 to take the CFO position at United Technologies Corp. (UTX).

Board of Directors: One related director (Chairman Kingsley) and ten independent directors.

ISS Governance QuickScore: Receives a medium ranking of 4/10, on a scale in which 1 indicates lower governance risk and 10 indicates higher governance risk. It receives one red flag, for Meeting and Voting Related Issues, and one green star, for Other Issues.

Unless otherwise noted, the management profile is based on information from Reuters.com and the company website.

Comments: The CEO/Chairman has extensive experience in both Pall and related work experience. Tenure in the CFO position is a concern, and the company receives a reasonable ranking in the ISS Governance QuickScore.

Ownership

At December 31, 2014, Pall was owned by five of the gurus followed by GuruFocus, and one of those holdings was small, at just 300 shares. Of the remaining four, Ron Baron (Trades, Portfolio) had the biggest holding, at 684,800 shares, while Meridian Funds (Trades, Portfolio) was close behind with 667,000 shares.

Institutional: nasdaq.com reports a very high level of institutional ownership, more than 95%:

Shorts: GuruFocus reports short ownership of 3.9% and provides this chart that indicates short interests generally range between 1% and 6%, and so is currently in about the middle of the range:

Insiders: About 1% according to GuruFocus; Yahoo! Finance reports CEO Kingsley is the biggest owner among inside interests, with 51,247 shares.

Pall by the Numbers

Comments: A market cap of almost $10.5 billion; a relatively high P/E and Return on Equity; a modest dividend and buyback ratio.

Financial Strength

GuruFocus awards Pall Corporation a 7/10 rating for Financial Strength and an 8/10 for Profitability & Growth:

The following chart shows the level of long-term debt over the company’s last two decades:

As for the Pall’s ability to generate income, the following chart shows EBITDA over the same period:

And, since hitting a low in 2009, Pall has also built its free cash flow:

Comments: While the GuruFocus automated system lets us know Pall’s Equity to Asset and Interest Coverage are not as strong now as they have been in the past, the essential metrics on long-term debt, EBTIDA, and free cash flow all go in the right direction.

Valuation

As of May 8, Pall had a place on the Undervalued Predictable screener.

It receives 4 out of 5 stars for predictability, which refers to its ability to consistently increase its earnings; let’s look again at that chart of EBITDA just above:

The ability of management to consistently grow earnings is interpreted by the market as a signal that the stock price should also grow relatively consistently.

The second half of the Undervalued Predictable formula involves the current price of the shares in relation to its Discount Cash Flow (DCF) valuation. In this case, the DCF comes in at $102, while the current price (mid-day, May 7) is $97.93. This represents a 4% discount from the DCF value.

Note that the Discount Cash Flow used in the screener differs slightly from the Discounted Cash Flow Calculator. GuruFocus explains it this way, “Compared with the DCF Calculator, in this page we use the EPS of the last fiscal year as default earnings, and the average of the first 5-year period and the second 5-year period as the default growth. While in the DCF calculator we use TTM EPS and 10-year compound growth rate as default.”

Dividends have grown along with the company’s earnings; the following chart shows year-by-year growth in green, and the trendline in blue:

Share buybacks have grown as well; this chart shows the buyback ratio, with the green line illustrating the ratio year-by-year and the blue line showing the 15-year trend:

P

Comments: This valuation exercise suggests the current price is a good price, but not necessarily a compelling price. At the same time, we can’t help but think a company like Pall with a strong history of revenue and earnings growth will not sell at a deep discount very often. Supporting that contention are the growing dividends and share buybacks.

Conclusions

This dip that Pall Corporation is currently experiencing could be an opportunity for investors.

If we accept that earnings for this year will come in a bit lower than previously expected, but still ahead of last year’s number, we have at least the starting point. Add to that increases in the dividend and share buybacks, along with analysts’ estimates for 2016, we have a reasonable case.

The company has a history that backs up the case, and plans for both organic growth and acquisitions, along with the resources to implement them.

Pall deserves a place on the short lists of investors looking for capital gains with modest but growing dividends.