Ecolab Inc. (NYSE:ECL) has seen a solid price recovery in the past year due to strong earnings and guidance coupled with high FCF. However, while I’m impressed with the firm’s performance, I don’t believe they deserve one premium price resulting in a holding rating.
Ecolab Inc. is a multinational company that provides water, sanitation and infection control solutions domestically and internationally. The business divides its activities into three segments: Global Institutional & Specialty, which supplies specialized cleaning products to the food service, hospitality and retail sectors; Global Industrial, which supports production; Global Healthcare & Life Sciences, which provides customized solutions for the healthcare, personal care and pharmaceutical industries; and more. The Other Division provides colloidal silica for manufacturing purposes and focuses on pest removal services. Dealers, distributors, corporate account staff and field salespeople all help distribute Ecolab’s wide range of products.
Ecolab boasts a market capitalization of $54.86 billion and has delivered an 8% return on invested capital. The stock’s 52-week trading range has seen highs of $193.15 and lows of $140.13. Currently valued at $192.40 and a GAAP P/E ratio of 44.64, Ecolab stock is currently trading near its highs. Additionally, the company’s GAAP P/E ratio is above that of industry peers, suggesting relative overvaluation.
Ecolab also pays a dividend of 1.10% representing a payout ratio of 49.29%. With minimal share repurchases due to the expensive price, I believe paying a dividend as FCF improves and investing in its core business will allow shareholders to capture value while the fundamentals try to play catch-up with the price. With relatively stable cash flows for a chemical company, Ecolab can improve this dividend as cash flows grow if ROIC is strained by the size of the firm which limits growth opportunities in its core operations. With revenue and EPS continuing to grow, I believe the firm’s cash flow situation should only improve resulting in dividend growth for years to come.
Performance Compared to the Broader Market
Over the past five years, Ecolab’s performance, when adjusted for dividends, has lagged the S&P 500. Given its premium price, the fact that the S&P 500 has more than doubled Ecolab’s returns underscores the need for the company to deliver performance. strong in the near future to justify its relatively expensive valuation.
When examining Ecolab’s balance sheet, it is clear that the firm is adequately leveraged to withstand macro and industry headwinds. With debt down 12% in the last year and interest coverage of 9.02, Ecolab has more than enough cash flow to pay off debt and obtain a competitive cost of debt due to its stable position. Also, with a high share price, Ecolab can raise money through the issuance of shares, which is logical for the firm in the short term to capitalize on the growth of the core business, while competitors will have difficulty reaching a capital of such. Finally, with a current ratio of 1.3 and an Altman-Z score of 3.62, Ecolab can remain solvent over the medium term, thus surviving the headwinds.
Ecolab also reported solid Q3 2023 earnings with EPS beating expectations by $0.02 at $1.54 and revenue missing by just $50 million at $3.96 billion, showing year-over-year growth of 7.9%. This performance demonstrates Ecolab’s ability to hedge against headwinds, such as volume declines in inflationary environments, and maintain profitability. I believe that with lower inflation and a rate change coming next year, Ecolab will be able to do better, which is illustrated in the estimates for the next few years, showing strong EPS growth.
Analysts currently rate Ecolab a “buy” with a 1-year average price target of $196.48, demonstrating a potential upside of 2.12%. This shows that while analysts are bullish on Ecolab’s performance, they also understand that the Ecolab premium is currently trading with limited upside unless future cash flows improve further.
Before calculating Ecolab’s fair value, I decided to find an appropriate discount rate by calculating the firm’s cost of capital using the Capital Asset Pricing Model. With a Beta of 0.9 and risk free rate of 4.21% based on The 10-year Treasury yield, I calculated a cost of capital of 8.23%. This is the return that investors seek in exchange for the risk of holding Ecolab stock.
I then decided to use a 5-year DCF equity model based on net income to find a fair value. I decided to use a discount rate of 8.23% without a risk premium due to the macro headwinds that appear to be easing along with the firm’s solid performance in recent reports. I also estimated that revenue and margins will continue to grow in line with analysts’ estimates. This resulted in a fair value of $122.42 demonstrating an overvaluation of 36%.
When you look at a sensitivity chart, it would take a discount rate of just 5% for Ecolab to be undervalued demonstrating the premium share price, but also the opportunity for value once interest rates fall causing the risk-free rate to decrease. Thus, I believe that once this opportunity arises and the price moves closer to fundamentals, Ecolab could be a value play sooner than we think.
Strategic Industry Diversification Improving Cyclicity
Additionally, I believe that Ecolab’s deliberate industry diversification is an essential component that will enable the business to offer its water, sanitation and energy technology to a wide range of industries. For example, Ecolab is a well-known supplier of sanitary and hygiene products for the food and beverage sector, which is essential to comply with the strictest food safety regulations. The company’s innovations help restaurants and food processing facilities maintain hygiene and compliance with strict requirements.
Ecolab is also a key player in the healthcare industry, providing hospitals and other healthcare facilities with the latest hygiene solutions. In this regard, the company’s experience contributes to the overall health and well-being of patients and medical professionals by maintaining a sanitary atmosphere. In addition to these markets, Ecolab also serves the hospitality, manufacturing and energy sectors, offering a diverse portfolio that takes into account the unique challenges each industry faces. This strategy emphasizes Ecolab’s commitment to sustainability and operational excellence across multiple industries, while also protecting it from economic fluctuations in each industry and positions it as a versatile and necessary partner in various markets.
With FCF growth as shown earlier in this article, I believe Ecolab will continue this strategy through aggressive R&D or acquisitions which will open up the firm’s core business to new customers creating synergies and less volatility in cash flows. This will stimulate long-term growth and result in greater pricing power due to economies of scale.
Competition: Many companies in the competitive water, sanitation and energy solutions market offer comparable goods and services. Ecolab’s price, profitability and market share could all be affected by increased competition.
Regulatory Compliance: Ecolab works in sectors where product efficiency, environmental norms and safety are strictly regulated. Changes in regulation can make compliance with the law more difficult and increase operating costs.
To summarize, I believe Ecolab is currently a drag because even though the firm has stable future cash flows, a stable balance sheet, and dividends, Ecolab is currently relatively overvalued based on my DCF assumptions.