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We are initiating coverage of the filtration and fluid management space with
a Market Weight stance. We have an Outperform rating on Flowserve,
Neutral ratings on Pall Corporation and Pentair, and an Underperform rating
on Donaldson.
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Unique end markets make company-specific drivers more important than
broad-based industry drivers, in our view. Each company within the space is
unique in terms of end markets, core competency, and products, and
therefore we focus on specific company issues rather than broad-based
industry concerns.
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Strong secular growth. Key themes such as rural-to-urban migration, water
scarcity, global warming, aging infrastructure, increased environmental
regulation, stricter standards for water and air quality, and an increased
need for efficiency in industrial processes will likely drive longer-term growth
for the sector.
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However, in the face of low visibility and with most end markets taking a leg
down and operating on the same cycle, we believe the filtration and fluid
management sector will likely remain range bound in the near term, and the
risk/reward is not compelling enough to warrant an Overweight stance on the
whole sector. We would look to build positions in companies that have
relatively noncyclical business mixes compared with peers, compelling
long-term growth opportunities, and strong balance sheets that position them
to develop new technologies and weather the downturn better.
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What could make us more positive or negative? We’re on the watch for:
o signs of stabilizing end-market demand and a reversion to
different end markets operating on different cycles.
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We prefer playing the following themes in filtration.
o Companies that are trading relatively close to historical trough
multiples with strong balance sheets, have technological
leadership, and have long-term growth prospects. Flowserve
stacks up best. Pall is second.
o Companies that have visibility into their business and where
early signs of stabilization of end-market demand could serve
as a catalyst (owing to short lead times, for example) in
moving up consensus numbers. Pentair stacks up best.
Table of Contents
Investment Summary 4
Strong Secular Growth Driven by Rural-to-Urban Migration 4
Water Scarcity + Global Warming = Higher Regulation = More Demand for Filtration5
Need For Maintaining and Building Water Infrastructure Drives Filtration/Fluid
Management Growth 6
However, Near-Term Weakness in End Markets Will Likely Keep Stocks Range
Bound 6
Company Investment Case Summaries 7
Industry Overview 11
Filtration Processes 14
Key Industry Drivers 16
Donaldson 16
Pall 16
Pentair 17
Flowserve 17
Other Metrics 17
Risks 21
Intense Competition in a Fragmented Industry 21
Risk of Not Delivering on Backlog 21
Cyclical End Markets 21
Changes in Product Mix and Pricing 21
Fluctuations in Foreign Exchange 21
Litigation and Tax Liability 21
Integrating Acquisitions 21
Valuation Methodology 22
Normalized Earnings 22
Pall- Most Diverse Name 23
Investment Summary 24
Business Overview 27
Life Sciences 28
Industrial 31
Management and the Board 34
Valuation 34
Return on Capital 37
Balance Sheet 38
Risks 38
Flowserve- Good Play on Global Infrastructure Build with Visibility 42
Investment Summary 43
Business Overview 49
Flow Pump Division 50
Flow Control Division 52
Flow Solutions Division 53
Management and the Board 54
Valuation 55
Return on Capital 58
Balance Sheet 59
Risks 59
Pentair- On Track, but Residential Exposure Keeps Us Cautious 61
Investment Summary 62
Business Overview 65
Water 66
Technical Products 68
Management and the Board 70
Valuation and Financials 71
Return on Capital 74
Balance Sheet 75
Risks 75
Donaldson- Nothing to Get Excited About Near Term 78
Investment Summary 79
Business Overview 82
Engine Products 83
Industrial Products 87
Management and the Board 90
Valuation 91
Return on Capital 94
Balance Sheet 95
Risks 95
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