Nalco awash in debt as returns flow to buyers

By James P. Miller
Tribune staff reporter
Published August 28, 2005

Nalco Holding Co., the Naperville provider of water-treatment services, has been a steady, low-profile performer over the years--almost to the point of being boring.

That stable predictability made the unglamorous 77-year-old company an ideal candidate to be bought, leveraged to the hilt and taken public again.

And that's why these days, while its buyout-fund owners conduct a briskly paced "cash-out" strategy, withdrawing a half billion dollars here and a half billion there, Nalco labors to service a punishing load of debt.

To be fair, there is nothing improper, or even all that unusual, about the process Nalco has undergone. But what has happened to the company provides a close-up look at the profit dynamics spurring the current rapid growth of private buyout funds.

In recent years, low interest rates and a blah stock market have dampened the returns available to many investors. So there's no shortage of buyers ready to snap up the junk bonds that fuel leveraged buyouts. Likewise, when investment firms like Blackstone Group of New York create special funds to do buyout deals, they receive a flood of cash from yield-hungry retirement funds, college endowments, pension plans, insurance companies and other investors anxious to participate in the LBO game.

In many respects, such deals aren't all that different from consumers who these days are buying and "flipping" houses using small down payments.

The returns with LBOs, magnified by hefty leverage, can be lucrative indeed: Nalco investors stand to get back somewhere around $2.61 for every dollar they put in less than two years ago.

Nalco makes specialized chemicals used to stop mineral buildup in boilers, clarify water in industrial cooling systems, turn wood pulp into paper and handle a host of similar chores. It goes beyond just selling chemicals, however. It usually assumes overall responsibility for its clients' water-treatment needs; company representatives work and consult at customer facilities.

"We're a problem-solving company," a spokesman says.

Nalco's latest adventures date to 1999, when French conglomerate Suez Lyonnaise des Eaux acquired Nalco for a hefty $4.1 billion. Suez enlarged the Naperville company by blending some of its own water-treatment operations into Nalco.

In November 2003 Suez sold Nalco to an investing group led by the New York private-investment firm Blackstone Group. Blackstone is among a group of buyout firms that specializes in buying companies in order to sell them at a profit later.

Because they typically use borrowed money to fund most of their purchases, buyout firms tend to prize companies (like Nalco) that generate a predictable stream of cash through thick economic times and thin, and which don't demand a lot of capital expenditures.

Nalco's new owners quickly installed a well-known chemical-industry figure, onetime Union Carbide CEO and Chairman William Joyce.

Joyce has focused on boosting free cash by trimming costs and growing sales. Although surging raw-material costs have recently put short-term pressure on profit margins, the 69-year-old executive's efforts have drawn generally positive reviews on Wall Street.

Even as Joyce, who declined to be interviewed for this article, began trying to squeeze more efficiencies from Nalco's operations, the company's new owners were putting additional stress on the company's balance sheet.

To buy Nalco, the investor group led by Blackstone had put up a total of $992 million. The rest of the purchase price was covered by borrowing--either loans from banks or money raised by the sale of high-yield junk bonds.

The LBO group didn't wait long to begin recovering its investment. Less than three months after the buy-in, Nalco sold an issue of senior discount notes and used the proceeds to pay the investor group a $445.8 million dividend.

That maneuver, known as a dividend recapitalization or "divi recap," has become more popular in recent years. But because it adds to the leverage of the acquired company, the trade publication "High Yield Report" recently labeled the divi recap "perhaps the most aggressive of all LBO transactions."

In November 2004, just one year after taking control of Nalco, the LBO group returned the company to public ownership. Nalco's private-equity owners had been hoping to price the IPO somewhere between $17 and $19 a share, but a lukewarm response obliged the LBO investors to mark down the offering to $15 apiece.

Still, the IPO provided the Blackstone group with a total of $544.5 million. Between the IPO and the earlier divi recap, the investors had in one year recovered all the money they had put into Nalco, and they still held a 64 percent stake in the debt-heavy company.

Earlier this month, the Blackstone holders sold off another 33.3 million shares at $18.41 apiece, extracting gross proceeds of more than $600 million--essentially pure profit--from their Nalco investment.

With its ownership stake lowered to less than half, the investor group (composed of funds affiliated with Blackstone, Apollo Management and Goldman Sachs Capital Partners) reduced its representation on Nalco's board from a majority to four of nine seats.

The group still has 57.2 million shares, which is about a 40 percent stake, with a value of $1.04 billion at current prices. A sale at that price would provide the LBO investors with a total indicated return of about $2.59 billion on an original investment of just under $1 billion.

Nalco's LBO investors have been doing fine. But what about the company itself?

Nalco's debt has ballooned under the twin load of the LBO and the recap. As of June 30, the company, which has sales of roughly $3 billion per year, had long-term debt of $3.37 billion.

Through the first six months of the current year, Nalco has paid a whopping $126.9 million in interest as it begins the long process of paying down the debt load that has enriched Blackstone, Apollo and Goldman. By comparison, in 1998, the last full year the company was publicly traded, Nalco paid only $26.5 million in interest for the entire year.

Despite the profit pressures that come from servicing its debt, Nalco shares have fared pretty well since the firm returned to public ownership. This summer, the stock briefly traded as high as $22.03, 47 percent above the offering price. Friday's closing price of $18.28 puts Nalco shares up 22 percent since the November IPO.

For one thing, Nalco's operations and leading position in its industry have remained solid despite the turbulence on the corporation's financial side.

The company enjoys a "stable, recurring revenue stream" that can be used to pay down debt, and the company has become a "leaner" organization under Joyce's leadership, observes William Blair & Co. analyst William Benton.

Asked if the company's big debt has hobbled Nalco's ability to make acquisitions or conduct research, Benton demurred. "I don't think they needed any acquisitions; they're well positioned already." What's more, Nalco is "not a heavily capital-intensive business operation," he said.

"It can handle a significant amount of debt."

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jpmiller@tribune.com

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Cash-out strategy

November 2003: The group acquires Nalco from Paris-based Suez for $4.1 billion by putting up only $992 million in cash; the rest is borrowed from banks or raised via sale of junk bonds.

January 2004: The investor group recovers nearly half its original investment. How? Nalco boosts its debt load further by selling high-interest notes and paying the $445.8 million in proceeds to the investors, in the form of a special dividend.

November 2004: The investors take Nalco public by selling some of their shares. The investors receive $544.5 million from the sale, completing the recovery of essentially all their original cash.

August 2004: The investors sell another 33.3 million shares, reducing their ownership to about 40 percent and generating gross proceeds of more than $600 million, all profit.

Future: The investor group still holds 57.2 million shares, valued at close to $1.04 billion. When those shares are sold, the proceeds will be pure profit.