Not many public companies ever attain blue-chip status, where they become the types of top-tier investments that can basically be held forever.
That's because blue-chip stocks have high standards to meet, such as a history of market dominance, outstanding financial strength, competitive margins, and reliable dividends.
While blue-chip stocks are relatively rare, it might be even less common to find a company that could be on its way to becoming one -- but I think I've found exactly such a stock.
This company can trace its roots back to World War II, when the firm's founder and some colleagues developed a uranium filtration process crucial for the construction of the first atomic weapons. In the ensuing seven decades, the company has become the world's largest manufacturer of filtration/purification products.
But with a market capitalization just under $10 billion, it hasn't yet grown into a full-fledged blue chip. (For example, GE is worth around $257 billion.) But I do consider it an excellent candidate, and I believe every investor should be aware of it.
I'm referring to Pall Corp. (NYSE: PLL), a little-known company that could one day be mentioned in the same breath as the likes of GE, Procter & Gamble, and other Forever Stocks.
Pall's operations are divided into two main segments: industrial and life sciences.
Industrial is slightly larger and accounts for 53% of total revenue (currently $2.7 billion annually), while the life sciences division generates 47%. Industrial markets include areas such as consumer electronics, municipal and industrial water, fuels, chemicals, and energy. Life sciences serves customers in research labs, pharmaceuticals, biotechnology, and hospitals, among other areas.
Pall has far too many products to describe here. However, key examples include filters that decontaminate gas reagents used in semiconductor production. The company also makes filters that help purify everything from vaccines to water. Pall's products come in all sizes, including water treatment systems that can process up to 150,000 gallons per day.
Going forward, the company should find strong growth opportunities in biotechnology, a fast-growing industry heavily reliant on filtration technologies in the research and production phases of drug and vaccine manufacturing. Stricter environmental regulations should spur solid demand from all sorts of manufacturers that will need filtration products to reduce emissions and prevent water contamination. As the world continues creeping toward better environmental stewardship, I also expect Pall to continue working with petroleum refiners and other fuel producers to develop filtration techniques that result in cleaner burning fuels.
|Pall makes filters that help purify everything from vaccines to water. Its products come in all sizes, including water treatment systems that can process 150,000 gallons a day.|
All this should enhance the firm's dominance and help expand its already diverse customer base. It should also help keep the focus squarely on repeat business, which currently accounts for 75% of sales. Repeat business is crucial for Pall because it carries high margins, whereas initial sales typically don't due to a lot of costly and time-consuming upfront customization. But once that's done, customers usually keep coming back to Pall for replacement filtration products since switching providers would be difficult and expensive.
In addition to market dominance and bright growth prospects, Pall has excellent financial strength by many measures. For instance, current assets of $2.1 billion are nearly three times current liabilities of $729 million, indicating plenty of liquidity to meet near-term obligations. Annual free cash flow has been rising quickly -- by nearly 33% a year (from $67 million to $274 million) during the five-year period from 2008 to 2013.
Thanks to repeat business, Pall's operating and net margins of 16.4% and 11.8% are markedly better than the industry averages of 13.8% and 8.5%. Net income rose an impressive 21.5% a year between 2008 and 2013 to $575 million. Leverage is well below average, as shown by a debt-to-equity ratio of just 0.3, compared with the industry value of 0.9.
At only 1.2%, I consider Pall's yield too paltry for a blue chip at this point. But a strong cash position and payout ratio of just 37% suggest there's room for dividend growth over time. In the meantime, Pall has at least established itself as a reliable dividend payer, providing a decent quarterly payout over the past decade.
Risks to Consider: The Industrial segment serves highly cyclical end markets and is therefore vulnerable to economic downturns, though the greater stability of life sciences does mitigate this risk somewhat.
Action to Take --> Since Pall appears to be a blue-chip stock in the making, I'd like to be able to recommend buying it now. However, shares have run up tremendously, climbing more than 350% during the past five years. So they've become quite richly valued, trading for nearly 32 times trailing 12-month earnings per share (EPS) of $2.77.
Based on consensus estimates for EPS to rise 12.3% a year, the stock has about 40% upside from the current price of $88 during the next five years. That's not bad, but I'd be more inclined to wait for at least a 10% pullback to around $80 before investing. In this market, I think the chances of such a pullback are high in the short term, and it would boost upside to about 55% five years out.