Nalco: Chemical Reaction

After experiencing some of the worst that capitalism has to offer, Nalco (symbol NLC) is finally ready to thrive, says Citigroup analyst P.J. Juvekar, who just upgraded the stock to a "buy." Nalco, the largest provider of water treatment and other chemical services that improve industrial processing, was taken private in 2003 and went public again in 2004.

The stock has gone nowhere since then for several good reasons. Nalco has $3.25 billion in debt -- giving it a debt-to-equity ratio of nearly five. But not much of that debt matures until 2010, and Nalco's cash flow should enable it to meet its interest obligations, Juvekar says. Another problem: The private equity investors who took the company private still own a big chunk of the stock. Juvekar thinks few will hang on for the long term, and their selling will depress the stock's price. Finally, Nalco has a pension plan that's $434 million underfunded.

But Nalco runs great businesses. As a maker of specialized chemicals, it uses a lot of energy, but it's increasingly able to pass along higher energy costs -- and increase prices even further, Juvekar says. A huge team of scientists -- the company owns more than 2,000 patents -- makes Nalco's services invaluable. More than two-thirds of the companies in Standard & Poor's 500-stock index do business with Nalco. What's more, those clients stay put: Fifteen of Nalco's biggest 20 clients have been with the company for more than ten years.

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The reason: Whether it's chemicals that help control corrosion in water pipes or that make paper plants more efficient, Nalco saves its clients big bucks. Generally, Nalco employees are stationed at its client's plants, but Juvekar says a new service enables Nalco to monitor plants -- and adjust chemical mixes -- remotely. He also believes that Nalco will benefit from plans to sell more of its services to smaller companies. For all these reasons, he thinks Nalco will be able to raise prices far more aggressively than do other analysts. Higher prices would mean higher profit margins and fatter earnings.

Based on a share price of $18, Nalco sells for 27 times Juvekar's 2006 earnings estimate of 67 cents per share. Other analysts are forecasting about the same earnings for this year, according to Thomson First Call. But Juvekar expects earnings to jump to $1.28 per share next year, while the average analyst foresees earnings of just 95 cents. Juvekar bases his estimate on computer modeling done after recent conversations with Nalco's chief executive, Bill Joyce, and its chief operating officer, Bill Roe. Nalco trades at just 14 times Juvekar's '07 profit forecast. Juvekar estimates that Nalco's earnings will grow 10% annually over the next five years.

--Steven Goldberg