Paired Trades: Short Nalco Holding, Long Met-Pro

Includes: MPR, NLC
by: Alan Brochstein, CFA

I have been posting to Seeking Alpha for over two years now. My articles tend to be focused on individual companies (negative or positive, but always with a conclusion), ideas that come from screening, thematic ideas, economic data interpretation, or investment strategy/outlook. My contributions rarely suffer from tersity! Today I am introducing a new category of articles: Paired Trades. I intend to publish these types of ideas on a regular basis. Like today's discussion, future contributions will be quite brief but hopefully highlight my underlying rationale.

A paired trade in its truest form allows an investor to simultaneously short a security that is expensive and go long one that is cheap without taking market risk. Here in Texas, we have an altogether different definition that allows you to double your risk (i.e short gold and short bonds). Kidding aside, the key element is to try to take out all sorts of risk by choosing appropriate candidates. They need to be in the same or similar industry and with somewhat similar market caps. Even in these cases, the securities can continue to diverge greatly from "value" due to other factors.

In the case of my paired trades, I am not necessarily saying to short one and buy the other, but instead suggesting to perhaps buy the cheaper one instead of the other if one is looking to invest in the industry, to sell the expensive one if one has a position in both, or to swap for the cheaper one if one owns the richer one. The point is to try to reconcile valuation differences. Doing one leg of a trade can result in a "Pyrrhic victory", where the one you buy goes down less than the other one, but you lose nonetheless, so caveat emptor.

So, with the background behind us, both Met-Pro (NYSE:MPR) and Nalco Holding (NYSE:NLC) are Industrials with exposure to water treatment and filtration, pollution control and other industries. They compete head-to-head very marginally from what I can gather: Water treatment. Even there, NLC focuses on larger customers. Here are some key metrics (click to enlarge):

In a normal economy, I wouldn't be paying attention to the table above, as NLC, despite being extremely leveraged, would cruise along just fine as it rolled over its debt and used its FCF to pay dividends, repurchase stock, do acquisitions, etc. These are not, however, normal times. The company has debt maturities of almost $1 billion each in 2010 and 2011, and the CEO doesn't seem to be too worried.

Here's what has been going on that may explain why the stock has performed well:

  • Large initial purchases by Buffett (NYSE:BRK.A) and Dell (NASDAQ:DELL) in Q4
  • Operational improvements in terms of EBITDA margin expansion

Here's what I think the market is missing:

  • Focus should be on pre-tax rather than operating margin, and it will be pressured from higher interest-rates and weaker margins as business contracts
  • covenant ratios aren't that close to being violated, but watch out with more chops to Goodwill or a deterioration in EBITDA.

MPR reports to have about 40% recurring revenue. I believe that due to its smaller scale and some mix differences, its level of profitability is lower than that of NLC and would normally suggest a discount on EV/Sales. MPR definitely got hit hard in Q4 in its capital equipment focused on pollution control. My interview with management suggests to me that the company is the leader in a bunch of small attractive niches with plenty of drivers to help them combat the economic headwinds the company faces. The extremely strong balance sheet and the relatively low valuation offers a lot more support to the stock price than NLC. After a strong year in 2008, the stock has "caught up" to the market after the recent disappointment, while NLC has gone the other way on folks noticing the Oracle of Omaha. I certainly don't want to "dis" Mr. Buffett, but like all humans, his timing has been off at times. In this case, he owns about $100mm of NLC, which pales in comparison to the debt they need to roll. I have an end-of-year target of 12 on MPR and 5 on NLC. (click on chart to enlarge)


Bottom-line: MPR is a gem of a company with a superb balance sheet that few follow and that just got its stock price chopped in half (allowing me to buy and to add to my model portfolio), while lots of folks have their eyes on NLC but are looking at the wrong thing (Buffett's interest rather than the weak balance sheet).

Disclosure: Long MPR