Paired Trades: Short Nalco Holding, Long Met-Pro

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 (MPR) and Nalco Holding (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 (BRK.A) and Dell (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

Comments

[User 128145:]

Very interesting. Good job.
Jeff F.

Mar 15 09:50 AM

[Jonathan Go...:]

Very insightful thank you. Maybe I'm missing something but it seems that NLC's free cash flow is approx. 3.3% of it's liabilities. After paying the 1.2% in dividends how are they supposed to cover the likely more than 2.1% in interest? It would seem that NLC is not just in poor shape but is in dire straights.

Thanks in advance for the clarification.

Mar 15 04:02 PM

[Jonathan Go...:]

Correction: The dividend should not be compared to FCF as it's yield on the stock... but still 3.3% FCF to liabilities seems too low to cover even interest. Please clarify.

Mar 15 04:05 PM

[Alan Brochs...:]

Jon, I don't get it, but that is the case. You would think that Warren Buffet and his group would be aware of the situation!

Mar 15 04:05 PM

[Jonathan Go...:]

They seem to be paying about 4.6% of total liabilities in interest (google) and - according to your data - after dividends, their FCF is about 2.8% of total liabilities (rough estimate). So does that mean they must be funding the shortfall via working capital (cash & equivalents)? If so then with the credit conditions in this market that doesn't give them much of a chance to avoid bankruptcy as they only have about $61M left in cash. When this runs out it's game over unless they can raise more capital no? Seeing as they are losing a ton of money this seems to be a great short as you've mentioned. I'm new to this and would be happy to get your input. Thank you.

Mar 15 07:45 PM

[Alan Brochs...:]

They aren't losing money - they are profitable. Bulls look at that profit and compare it to the equity value and smile. I look at it and compare it to the debt burden and laugh.

Game over, or at least changed in my opinion. The days of just rolling over the debt are over. While some of their business is very stable, not all of it is, and the deceleration was quite apparent. I didn't mention in the article, but one of my favorite yellow flags waved in Q4: Massive inventory growth at the same time as sales stagnated.

This is analogous to picking up on the tell in a poker game in my opinion. Sales were flat year-over-year, yet inventory grew a stunning 18% (inventory up $60mm). Sequentially (in $), sales dropped $85mm while inventory fell just $37mm. Next quarter should be interesting...


On Mar 15 07:45 PM Jonathan Goldberg wrote:

> They seem to be paying about 4.6% of total liabilities in interest
> (google) and - according to your data - after dividends, their FCF
> is about 2.8% of total liabilities (rough estimate). So does that
> mean they must be funding the shortfall via working capital (cash
> & equivalents)? If so then with the credit conditions in this
> market that doesn't give them much of a chance to avoid bankruptcy
> as they only have about $61M left in cash. When this runs out it's
> game over unless they can raise more capital no? Seeing as they are
> losing a ton of money this seems to be a great short as you've mentioned.
> I'm new to this and would be happy to get your input. Thank you.

Mar 15 08:34 PM

[Jonathan Go...:]

Ok thank you. I just took another look and there was just an unusual expense in '08 - so they are profitable. As I said I'm new to this. Thank you.

Mar 15 09:14 PM

[kewgardens:]

Great job, as usual.

By the way, would you put PLL in the same category as NLC (i.e., another potential water treatment short)? Or has the recent sell-off limited the upside on such a trade?

Mar 16 04:58 AM

[Alan Brochs...:]

I have never been much of a fan of PLL, but I haven't looked at it in a while. It looks expensive on a P/B or P/TB basis, which just means that there is downside if the earnings continue to fade. Their situation doesn't appear to be as challenging as NLC's, not even close.


On Mar 16 04:58 AM kewgardens wrote:

> Great job, as usual.
>
> By the way, would you put PLL in the same category as NLC (i.e.,
> another potential water treatment short)? Or has the recent sell-off
> limited the upside on such a trade?

Mar 16 08:34 AM

[CloroxCowboy:]

Alan,

Nice to see that someone is coming out with a series on pairs trading. I have a question regarding this particular trade. Financials aside, when I look at the price ratio chart you attached it seems that the main portion of this correction might have happened already. My question is: Are you doing any analysis on the quantitative side, looking for favorable co-integration characteristics in these pairs, etc? I tend more to the techinal in my pairs trades, evaluating the movements of price ratio more than company financials, so I'm very interested to see how a strategy based largely on fundamentals (that is just my assumption from the article) will go.

Mar 16 09:37 AM

[CloroxCowboy:]

Typo above: should be "I tend more to the technical..."

Mar 16 09:40 AM

[Alan Brochs...:]

I am not sure I follow - there has been a very sharp reversal from a trend that was in force (of MPR doing better relatively than NLC). I provided a chart that shows this. I believe that these two companies face roughly similar fundamental outlooks, but there is a substantive difference in their financial risk but similar valuations. Quantitatively, MPR is extremely oversold after plunging following its recent earnings release. I hope this clarifies - if not, try me again please!

Mar 16 10:19 AM

[CloroxCowboy:]

Thanks for clarifying, I see what you're trying to do now. This is not the same type of pairs trading I do so I wanted to fully understand your analysis. I think it's just a difference between technical vs fundamental valuations.

For example, my style would be to find a pair where the price ratio is relatively stationary (highly cointegrated) over several years, and enter trades at several standard deviations from the mean. I would exit on a return to the mean, rinse, and repeat. Basically I just look for statistical "tails" but rarely use fundamentals or events when I value my trades. In fact, I try to specifically trade pairs with very little recent news that have slowly drifted apart (for no apparent reason) and wait for a quick rebound to the "correct" prices.

Your method seems to be different than mine, and I can see that it would require more in-depth fundamental research to trade this way. Don't get me wrong though, I think both methods can be successful. I am definitely looking forward to reading about your future trades and learning more about this style. Good luck and thanks for the reply!

Mar 16 04:26 PM

[Alan Brochs...:]

11 days later, and MPR is quoted 9.50 from 7.30 and NLC is at 12.30 from 11.98. I believe that NLC is most likely still a short but I am less enthusiastic in the near-term about MPR. In my conservative growth/balanced model portfolio (investbymodel.com), we trimmed it earlier this week, and I have pared my position down by 70% over the past couple of days.

Mar 25 11:07 AM

[Ricard:]

MPR looks excellent but pales in comparison to your recent commentary of COLM. Well done, thanks again.

May 03 01:40 PM