For a company whose earnings are expected to double this year and grow by another 30% in 2007, Houston-based oilfield-services outfit
has had a hard time of late impressing Wall Street.
Activist investor David Nierenberg believes he can change that.
Natco, which sells equipment for oil and gas drilling, had a nice run last summer, its shares vaulting from $10 in May to the high $20s by October. They've made halting progress since, closing at $28.54 Thursday. The shares sport a below-market valuation in a sector that is experiencing some of its best growth in a generation.
"This is a growing company with very little debt," says Lewis Kreps, an analyst at Aperion Group, who has a buy rating on the stock with a $38.50 target. "They have very little cash needs because of the cash flow they have."
At current prices, Natco fetches 17 times next year's projected earnings, using Thomson First Call data. Rivals
Gulf Island Fabrication
trade for about 20 times earnings, despite similar growth trajectories.
Why the discount? Part of the reason is Natco's history. The company had some lean years at the start of the decade, with earnings declining for several years before picking up in 2005. Another factor is the company's small float and low volume. Only about 11 million shares are available for trading, and just 143,000 change hands on the average day, according to data on Yahoo! Finance.
Enter Nierenberg, whose D3 Family Funds recently bought up 87% of an issue of Natco preferred stock that has been cluttering up the company's balance sheet since early 2003. Nierenberg's shares are convertible into 1.8 million common shares, and the manager is on record as saying he plans to exercise that option in the near future.
Nierenberg, an activist investor of a gentler bent, says his purchase is designed to unlock value at Natco by removing the blemish of the preferred issue and adding to the public float. The deal was struck on April 7 at a price that effectively will allow Nierenberg's fund to convert the preferred to common stock at a price of $25.35 a share -- a nearly 10% discount to where Natco was trading that day.
According to Nierenberg, the transaction is not about booking a quick profit on discounted shares. He says he plans to hold the stock and wait for the longer-term benefits of his investment to accrue. "We made this investment because we believe Natco is an undervalued, under-owned and under-followed company whose excellent growth prospects, strong management and governance, improving operating results, and leading competitive position in a fragmented market, ultimately will be more widely recognized and appropriately valued," the filing says. One sign of Nierenberg's confidence: He doesn't plan to assume a board seat to which his stake entitles him. "We believe Natco has a strong board and a serious commitment to good corporate governance, making it unnecessary for us to take a seat at the table," his filing says.
Nierenberg says his motive was simply to buy a big stake in Natco with minimal disruption. His purchase of hard-to-trade preferred, he argues, is another sign of his long-term commitment to the company.
The stealth with which the transaction was conducted was also positive for the stock. Although the filing doesn't specify it, Nierenberg bought the shares from one seller: private equity firm Lime Rock Partners. Lime Rock could have converted the shares and sold them publicly, a move that would have likely depressed the price. Instead, it chose to sell the shares quietly in one block and to a limited number of investors.
"The quiet exit of Lime Rock to D3 Family of Funds avoided the potential negative trading implications of a longer exit with a public offering," says Dan Pickering, president of Pickering Energy Partners, an energy research boutique. In fact, the market hardly noticed. The stock is only covered by three analysts that may not have picked up on the filing, yet, Pickering notes. "The information is still making its way to the market," he says.
The timing of the sale was right for Lime Rock, too. The Connecticut-based private equity firm bought the shares in March near $10 and held them for about three years, almost tripling its original investment. Mark McCall, chief financial officer at Lime Rock, didn't return a call.
Should investors worry about the dilutive effect of a large purchase of convertible securities? After all, Nierenberg makes no secret of his intent to convert all his shares into common, which would give him a 9.4% stake in the company and dilute existing holders. In this case, though, the potential for dilution is no secret to the market. Lime Rock has been in the money on the convertibles for quite a while, and as is always the case, the company's earnings estimates reflect the likelihood of extra shares.
Nierenberg says he is in negotiations with the company on how to best convert the preferred shares. It won't happen before May, when the company announces its first-quarter results, but is "a done deal" eventually, he says.
"It is likely that D3 is pushing for an agreement that will state that the future value of the dividend is reflected in some sort of accelerated payments," says Pickering. John Clarke, Natco's CEO, confirmed that this is an option, but declined to elaborate.
So, what benefit does Nierenberg foresee from his complicated involvement in the preferred stock of a semiobscure company? First, there is a "cosmetic" effect. The conversion of all the preferred will give Natco a conventional balance sheet. "A good company would want to get rid of its preferred," Nierenberg says, because "it may suggest that the company has difficulty funding itself."
He said that it's relatively unusual for a public company that isn't a utility or a railroad to have an outstanding class of preferred and that the "anomaly may discourage people from considering the company."
Second, the preferred are expensive for the company. The shares carry a 10% annual payout and the income earned on a preferred is considered to be dividend, not interest. Therefore, the payments are not tax deductible for the company. "It would be in the company's best interest if they took this high-cost piece of paper and took it out of the capital structure," says Pickering. The removal of this payout would also increase the earnings per share. The dividend payment costs the company $1.5 million a year.
Finally, the conversion will potentially lead to more liquidity for the stock by removing a class of nonregistered securities and replacing them with common shares. When converted, the shares would be tradable and available to a broader group of investors, not just private companies.