Filtration companies have enjoyed healthy valuations for a while now, buoyed by a combination of captive consumables sales, increasing performance demands in fields like biopharmaceuticals and electronics, and perceived attractiveness as acquisition targets. At some point, though, the rubber has to meet the road and robust valuations have to be legitimized by solid internal growth.

That's looking increasingly problematic for Pall (NYSE:PLL). Not only was growth mediocre in the fiscal third quarter, but ongoing weakness in Europe and emerging weakness in some industrial markets suggest little immediate improvement. Add some uncertainties about management's strategic direction and it's hard to see why investors should pay a premium to own Pall.

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Q3 Results Come in Light
Pall's fiscal third quarter results were a disappointment. Sales rose about 1% on a reported basis and about 2.5% on a constant currency basis, even when adjusting for the sale of the blood filtration business. Different sources reported different average analyst estimates, one suggesting that Pall's revenue missed, another that Pall beat, but either way, growth was not especially strong.

Pall also failed to generate much profit or margin momentum. Gross margin remained consistent year on year, as a slight improvement in life sciences margins was counter-balanced by declines across the industrial businesses. Operating income fell 10%, with a sizable drop in the profitability of the industrial segment.

SEE: Zooming In On Net Operating Income

Is Selling the Blood Business the Right Move?
The decision is over a month old now, but Pall is going to be selling its blood filtration business to Haemonetics (NYSE:HAE) for $550 million in cash. In terms of valuation, Pall got a respectable price for a slow-growth medical business.

The question is whether this is really a good move for the long-term. Yes, this fits in with an overall strategy to improve the growth prospects of the company, but the blood business offered good margins and Pall's business held its own with the likes of Merck KgA and General Electric (NYSE:GE). What's more, management has been vague about its intentions for the proceeds - further M&A seems like a good bet, but valuations in the sector are not exactly cheap.

SEE: Equity Valuation In Good Times And Bad

Where's the Growth?
It's difficult to look at Pall's performance in the industrial sector and come away feeling great about the tenor of business. Process technologies was up only about 5% in local currencies, as weakness in municipal water and "machinery" offset growth in the fuels and chemicals segment. Ongoing weakness in electronics was not surprising, but the sluggish performance in aerospace was a bit of a concern.

I'm not entirely sure what to make of these trends. Donaldson (NYSE:DCI) and Clarcor (NYSE:CLC) both reported stronger results from their industrial filtration businesses, as did GE, so I wonder if Pall's results reflect an increasing weakness in these markets - something that recent reports from other industrial companies would seem to corroborate.

SEE: Measuring And Managing Investment Risk

The Bottom Line
Pall has a relatively new CEO at the helm, and it seems clear that he is looking to take the company in a different direction. Over the long term, that could pay off - it is hard to imagine how filtration needs won't get more sophisticated and demanding across the board in the years to come.

All of that said, and trying to avoid overacting to a slowdown in the business, Pall still just seems too expensive. Pall has grown its free cash flow at roughly a 10% annual rate over the last decade, and even if the company matches that over the next decade, the stock is much too expensive. As it stands today, Pall needs to grow free cash flow at a nearly 15% compound rate just to merit today's valuation, and that doesn't seem to leave a lot on the table for new investors.

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At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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