NLC Water/Energy Treatment Company Looks Attractive

I have recently spent some time researching Nalco Holdings (NLC) as an investment possibility. There are several things that I like about this company that I think will make it a great addition to our portfolio. Perhaps the most intriguing qualities of NLC is the diversity of its products & services, the markets in which they operate, their large customer base, and the reliability of their cash flow streams. When it comes to their products & services, they operate in three segments: Industrial and Institutional Services, Energy Services, and Paper Services.  The primary focus of these services are used in water treatment, energy, and air to deliver cost reductions to their clients. The following is a more detailed description from their 10-K that I think does a much better job of describing the value added here:

“Our programs and services are used in water treatment applications to prevent corrosion, contamination and the buildup of harmful deposits and in production processes to enhance process efficiency, extend asset life, improve our customers’ end products, and enhance air quality. We also help our customers reduce energy, water and other natural resource consumption, minimizing environmental releases while boosting their bottom line. Together our comprehensive solutions contribute to the sustainable development of customer operations.”

NLC’s revenue mix is extremely diverse. It derives 27% from upstream/downstream refining and petrochemical manufacturing (for example: Cheveron when it drills at a well hires a NLC engineer to over see the process and make sure the water treatment and water inflows/outflows and various other things are being done correctly as to preserve the resources of the well) , 21% from the paper industry, and the remaining 52% from general industrial and institutional customers (obviously this last category is a very diverse and general categorization). In addition, NLC serves over 60,000 different companies across the world (over 130 countries) in many different industries. According the NLC’s management, their largest customer makes up less than 3% of revenues. In many ways, NLC’s business reminds me a lot of Transocean’s. They too have the largest market share in their specific industry (RIG in deep rigs, NLC in industrial water treatment), a diverse cash flow generating revenue mix, high return on their assets, and solid long term contracts with the largest and most dependable companies in the world such as Exxon, BP, Cheveron, etc. When asked about these same issues in a presentation recently, this is what their management had to say:

“What you get out of here is some very interesting attributes of Nalco as an investment, are literally 70,000 customer locations around the world. Every industry you can think of, 140 countries. Our largest customer would easily be the super majors, the largest of them not even 3% of revenue. So there’s great stability in this cash flow, because you don’t change water treatment companies month-to-month. It’s a terribly disrupted process to take Nalco out, put somebody else in, unfortunately it can also be awkward to take someone else out and put Nalco in. And with the door opening that we have there we think is just most advanced technology, and we can demonstrate back dates to customers it’s worth their while to go through that.

I think we note here that of our top 20 customers, 19 of them have been with us for more than 10 years. Market share doesn’t move quickly in this space at all.”

This is another question and answer that I thought was interesting from the presentation:

“Do you have any international customers, let’s say in the United States that are doing things oversees that’s sort of pulling your business with them through the expansion of the International operations?”

“Sure, question is do we have international customers operating here that invite us or take us abroad or force us to go abroad. Certainly yes, and that’s been true for a long time. Companies like BP, or Chevron, Texaco et cetera truly operate on a global basis. We have been servicing them for years in the Americas and when they say we are going to Kazakhstan or we are going to the Caspian they mean “we” [Nalco] are going to the Caspian and they want it done for them there, or they want it done for them in the West Africa, exactly the same way we are doing it for them in the Gulf. And I think it’s one of the reasons the global deployment we have is a great advantage over some of the regional players.”

Another great thing about this company is their cash flow generation and it is perhaps their most attractive aspect from an investing standpoint. They currently have a cash flow yield of over 10% which is extremely attractive considering the solid steady nature of these cash flows. In other words, Nalco trades at just 8.5 times cash flow vs an industry average of 21.  This is perhaps the one and only thing that can help reduce worries regarding the company’s heavily leveraged balance sheet. The cash flow generation alone is more than enough to meant any near term debt obligations but yet the company still has an extremely leveraged capital structure (which I can’t figure out why they haven’t paid down). Currently, the company’s debt stands at over 4 times EBITDA or roughly 85% of its capital structure. This is one aspect that led to the sharp fall in the share price during the peak of the credit crisis, and what in my opinion is keeping it from breaking into new highs. Regardless of their debt positions, I think that this cash flow generation is important not only from a liquidity standpoint but also to help fuel both organic and acquisition-based growth for the company. In my opinion, the cash flow generation coupled with the diversity and stability of their earnings is what makes Warren Buffett (arguably the best value investor) likes this company so much (he is the largest shareholder). Here is what their CFO said regarding their debt position:

<Q>: What’s your leverage target? Are you comfortable with where you are? Where do you want to take it?
<A – Bradley J. Bell, Executive Vice President, Chief Financial Officer>: Yeah, I’ve been comfortable since the early days after the LBO personally I mean, business generates lots of cash. And I think a year and a half ago that question didn’t come up too terribly often because by and large the Street wasn’t too concerned about companies with high degrees of leverage if the cash covered it. I think the world shifted last year and I think we got into the fourth quarter, I think it showed up very strongly in our stock price. So we got hit pretty hard. I think there was indiscriminate selling of companies that had high leverage.

“So I think we will be probably all better served if the leverage multiple began with a three rather than with a four. We don’t have a target that really says we can’t look at M&A ideas until we get 3.X that really hasn’t entered the thinking. If you just go sit down in the corner for a while, this business delevers because EBITDA is growing and cash flow is coming in in excess of what we need to expand the business. So I think the trend that I showed you a couple of pages back, I think this goes on almost automatically and we would be there. I think that it’s not a goal of the company per se, but I think we would achieve investment grade status at leverage multiples higher than the so-called specialty chem peer group that we’re often compared to. Just given the stability, if you read Moody’s and S&Ps comments about the company, they love the portfolio, they just think we have a little too much debt. I don’t think we need to get to the levels of some of the specialty chem “peers” before they do something nice for us on that front. But again, I think it’s more a case of how can we keep growing this business because this cash flow services the debt well, we don’t stay up late at night worrying about that. It’s the diversity of the cash flow, it’s the annuity nature of the customer relationship, very different than selling product Others”

I am very bullish on the long term prospects for water treatment/water resource companies. NLC is unique in that it has operations in both the chemical treatment of water and industrial water usage but also technologies that help produce more efficient water, oil, and other resource extractions. Their services not only make the process more efficient by cutting cost and reducing the amount of wasted resources saving their clients money, but their services also help reduce the harmful effects that these processes cause on our environment, thus classifying them in the very attractive high growth industry of green tech. The company is also taking large steps to expand its business into clean air, developing products that will reduce the pollutants from coal and other harmful energy sources. This is a huge opportunity for them to expand their market share in these high growth markets, especially with their global reach they will be able to tap into their already established international resources in high growth markets such as China and India. This is why I do not think they are terribly expensive at current levels (especially from a long term standpoint), trading at 20 times forward earnings. With the prospects of new markets, high growth in these attractive markets, and higher emphasis placed on these services from governments around the world, this could arguably be trading at a much higher multiple. Here is a breakdown from their 10-K

Form 10-K

Our Segments and Offerings

		Industrial and Institutional Services		Energy Services		Paper Services
Market Positions		$7.5 billion global market (1)(2)		$4.8 billion global market (1)		$8.5 billion global market (1)
		#1 Market Position		#1 Market Position		#3 Market Position
Market Share (3)		18%		32%		9%
2008 Net Sales(4)		$1,813 million		$1,506 million		$777 million
Representative		Food, Beverage		Exploration		Fine Paper
Markets		Buildings, Hotels, Hospitals		Field Development		Uncoated Free Sheet
		Chemicals, Pharmaceuticals		Production		Coated Free Sheet
		Manufacturing, Metals, Power Utilities, Mining, Marine		Refining		Newsprint
				PetrochemicalManufacturing		Tissue and TowelContainerboard

On the Flip Side:

There are some negatives that need to be noted enable to fully understand the risk with investing in this company.

While they are clearly the markets leaders in each of their operating segments, this is a very competitive market place that could easily see the big boys like GE place a bigger focus on. While NLC has a commanding market share of over 18% vs GE’s less than 5%, it should not be ignored that GE could easily steal some of this away considering their global reach. (Could also mean that GE could potentially buy them out to gain more expsoure to these high growth markets….but who knows just a thought).

Also, it is clearly obvious that NLC’s debt level is of some major concern. While this is usually an alarming aspect for a company, I am not too concerned with their debt as I have been with other companies. This mainly due to their solid cash flow generation and the stability and diversity of these cash flows. The company can easily meet its short term obligations while still having funds set aside for any acquisitions that they might make. They are currently paying back their short term debt due November of 2010 early resulting in interest savings of nearly $15 million dollars.

Another issue that I have been reading about is allegations that NLC is canceling their lump sum pension agreements. This is not good news. Usually, it is not a very good situation when a company pisses off its employees by canceling their benefits that they have worked for so long to get and then reward their executives with large bonuses…which is apparently what NLC is doing. This is a major concern for me as I have always believed a solid management is very important when considering investing in a particular company. On the flip side of this, NLC’s new (a year or so) CEO Erik Fyrwald (a.k.a Erik the Great as some investors refer to him) has done a really great job of turning this company around. He was a former exec at Du Pont and stepped into the CEO role during a very tough time for NLC. A time where they were extremely debt burdened and the economic crisis was threatening the company’s growth and future. Since he had taken the reigns, they have introduced new products and technology, won key long term contracts with fortune 500 companies, reduced their debt, captured more market share, and stepped into some new high growth markets, focusing on services and products that deal with air pollution reduction. I think this guy will continue to lead them towards solid growth and I am confident in his ability to run this company. Regardless, according to several people familiar with the company, NLC’s pension fund remains 80% under funded and the cancellation of their lump sum agreement is likely to be used to pay back some debt and or refund their employee benefit plans, and hopefully not the executives trips to the Bahamas.

Overall I think the NLC will be a great long term buy. I could easily see the stock correcting a bit as it is up nearly 200% since last Feb (dang what an opportunity at $9!). I also don’t think that it is an extremely cheap stock at these levels and could see some healthy pullback as earnings season approaches. I think Buffett being the major shareholder is not always a guarantee of it being a success but it does not hurt. Buffett usually has to research and valuations down on his picks and if anything people will see that he holds the company and maybe buy for that very reason. I feel that it is quite possible we could get in for under $25 or even average down our costs through several purchase points but overall this is a very attractive company that operates (and is the leader) in a very attractive industry in my opinion.

Just a side note: Another way we could play this is through the purchase of the ETF FIW, one that I have watched for awhile and seems to be outperforming its peers. Its top holding is NLC and it also holds positions in LNN, DHR, PICO, and many others. This ETF is a very attractive way to play the industry as a whole. It has an expense ratio of .60. Only downside is that there is not much volume for this…not too much of a problem since I would presumably be holding a small position (unless I hit the lotto super jackpot soon)

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Here are some articles to read if you get the chance:

http://seekingalpha.com/article/105035-interview-with-nalco-holding-company

http://www.dailywealth.com/archive/2009/feb/2009_feb_28.asp