Contents
Ecolab Inc. (ECL), a high quality company currently overvalued, is one of the companies I have on my 'Watch List'.
Summary
- Ecolab Inc. is the global leader in water, hygiene and energy technologies and services that protect people and vital resources.
- It has distributed dividends uninterrupted for over 80 years. The typically low dividend yield (currently ~1%) may result in many investors overlooking ECL as a potential investment.
- ECL’s positive Free Cash Flow has improved over the years to the extent where FCF was just under 10% of FY2018 Revenue.
- I currently view ECL as overvalued and provide a level at which I would consider initiating a position.
Introduction
At the outset of my recent 3M (MMM) article I mentioned how in recent months I have found it increasingly difficult to identify attractively valued companies. In most cases my analysis has led me to the conclusion to patiently wait on the sidelines or to employ the use of options to skim additional income as opposed to the outright purchase of shares.
On the rare occasion I have deemed the companies I have analyzed to be reasonably valued. Recently, following the release of Q2 2019 results, I have acquired additional shares in the following major Canadian financial institutions.
- The Bank of Montreal (BMO)
- The Bank of Nova Scotia (BNS)
- The Canadian Imperial Bank of Commerce (CM)
- The Royal Bank of Canada (RY)
- The Toronto-Dominion Bank (TD)
For the most part, however, I have refrained from deploying new money as the valuation of many great companies which appeal to me appears to be elevated.
I maintain a relatively concentrated portfolio and my plan is to increase my exposure to several of my current holdings when I view valuations as attractive. I do, however, also maintain a list of companies in which I would like to initiate a position when I view their valuation as acceptable.
In the next few articles I will look at several of the companies in which I would like to initiate a position; I begin this series of articles with Ecolab Inc. (ECL).
In this March 14, 2018 article I looked at ECL but came to the conclusion that it was too richly valued for my liking.
One quick look at ECL’s stock chart for the period subsequent to that article and it is clear I erred in deciding to pass on initiating a position.
I had an opportunity to initiate a position when ECL’s share price pulled back in December 2018 but I opted to deploy funds toward the purchase of shares in other companies.
Business Overview
I provided a business overview in my March 14, 2018 article but that article was restricted to subscribers. I, therefore, provide the following brief overview.
ECL is a global leader in water, hygiene and energy technologies and services. It delivers comprehensive programs, products, and services to promote safe food, maintain clean environments, optimize water and energy use, and develop and improve operating efficiencies in the food, healthcare, energy, hospitality and industrial markets in more than 170 countries.
Its reportable business segments are:
Global Industrial
This segment consists of Water, Food & Beverage, Paper, Life Sciences, and Textile Care.
Competition in this segment is led by a few large companies with the rest of the market served by smaller entities focused on more limited geographic regions or a smaller subset of products and services.
Global Institutional
This reporting segment consists of the Institutional, Specialty, and Healthcare operating segments which provide specialized cleaning and sanitizing products to the foodservice, hospitality, lodging, healthcare, government, education, and retail industries.
Competition consists of a small number of large companies selling directly or through distributors on a national or international scale. In addition, there are numerous smaller regional or local competitors which focus on more limited geographies, product lines and/or end-use customer segments.
Global Energy
This operates primarily under the Nalco Champion name. It consists of the Energy operating segment which serves the process chemicals and water treatment needs of the global petroleum and petrochemical industries in upstream and downstream applications.
Competition consists of a small number of large multinational companies as well as smaller regional niche companies focused on limited geographical areas.
Other
This consists of the Pest Control and Colloidal Technologies Group.
Barriers to Entry
ECL’s business is subject to various legislative enactments and regulations related to the protection of the environment and public health. The most significant environmental and regulatory matters ECL and its competitors must contend with are:
- Ingredient Legislation;
- Toxic Substances Control Act (United States);
- Registration, Evaluation and Authorization of Chemicals (EU);
- Globally Harmonized System of Classification and Labelling of Chemicals (United Nations);
- Pesticide and Biocide Legislation;
- FDA Antimicrobial Product Requirements;
- Medical Device and Drug Product Requirements;
- Equipment subject to state and local regulatory requirements and UL, NSF, and other approval requirements.
Q1 2019 Results
ECL’s Q1 2019 Earnings Release of April 30, 2019 can be accessed here and here and its accompanying Earnings Presentation can be accessed here.
Risk
Moody’s withdrew its A2 rating in February 2007 but reinstated coverage in July 2015 at the Baa1 level (top tier of the lower medium grade category).
S&P Global assigned an A- rating in March 2016. This rating is the lowest tier within the upper medium grade category and is one notch higher than Moody’s rating.
In addition to relying on the risk rating assigned by two major ratings agencies I also look at the schedule of a company’s short-term and long-term debt obligations. I look at the effective interest rate of the various obligations and well as when the debt obligations mature.
If this is an area of interest to you may wish to click here to access ECL’s 2018 Annual Report. The Debt and Interest section of the 10-K begins on page 87 of 126.
Free Cash Flow (FCF)
Earnings can be manipulated and while I do look at a company’s valuation based on earnings per share and adjusted earnings per share I will avoid companies which do not have a track record of consistently generating positive FCF.
A great overview of FCF and why it is such an important metric to include in the analysis of a company can be found here.
Looking at the following table we see that ECL’s FCF trend over the 2008 – 2018 timeframe is favorable. We also see the extent to which FCF is generated relative to Revenue has also improved in the last few years.
Valuation
On February 20, 2018 ECL released Q4 and FY2017 results in which it reported 2017 diluted EPS of $5.13 which included special gains and charges and discrete tax items. Excluding these items, 2017 adjusted diluted EPS was $4.69. On the date earnings were released, shares closed at $131.72 giving us a diluted PE of 25.68 and an adjusted diluted PE of 28.09.
Guidance for FY2018 was adjusted diluted EPS of $5.25 - $5.45 representing a 12% - 16% increase from FY2017. Using this guidance we arrived at a forward adjusted diluted PE range of 24.17 – 25.09.
Fast forward to February 19, 2019 and ECL reported FY2018 diluted EPS of $4.88 and adjusted diluted EPS of $5.25; shares closed at $167.31 on the day of this earnings release. Using this closing stock price we get a diluted PE of 34.28 and an adjusted diluted PE of 31.87.
When FY2018 earnings were released, ECL also provided FY2019 guidance calling for adjusted diluted EPS $5.80 - $6.00. Using the $167.31 share price we arrive at a forward adjusted diluted PE of ~27.89 - ~28.85.
As I compose this article we have a $182.59 share price. This means ECL’s forward adjusted diluted PE range is even less favorable than almost a month ago; the current range is now 30.43 – 31.48.
In my opinion, ECL is too richly valued for me to consider initiating a position.
ECL has paid cash dividends on its common stock for over 80 consecutive years.
The following chart reflects ECL’s annual dividend growth and the compound annual growth for the 2000 – 2019 timeframe.
ECL’s current $0.46 quarterly dividend ($1.84/year) provides investors with a ~1% dividend yield on the basis of the current $182.59 share price.
The current $1.84/year dividend represents a ~37.7% dividend payout ratio based on FY2018 diluted EPS of $4.88. Over the past 10 years ECL’s dividend payout ratio has ranged from a high 20% to a high 30%. I view this range as providing ECL with ample flexibility.
Management has indicated that increasing the dividend in line with earnings growth is a priority. This is followed by acquisitions and share repurchases.
Management has communicated to the investment community on several occasions that share buybacks will be used to neutralize share dilution. In FY2014 the average number of diluted shares outstanding amounted to ~306 million shares. In FY2018 this had been reduced to ~293 million shares.
Final Thoughts
Using the $5.90 mid-point of ECL’s FY2019 adjusted diluted EPS guidance of $5.80 - $6.00 and a price of ~$148 results in a forward adjusted PE of ~25. Some investors may view this valuation as wishful thinking but in December 2018 ECL’s share price retraced to the high $130s. Shares were valued at ~23.6 times forward adjusted EPS.
I have no intention of initiating a position in ECL at the current valuation. I am, however, monitoring ECL in the hopes that its share price retraces to mid-December 2018 levels. Should this materialize I would very seriously weigh initiating a position in ECL relative to other attractively valued opportunities.
I hope you found this article helpful and wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I do not hold a position in ECL and do not intend to initiate a position within the next 72 hours.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
