2023-12-04 22:16:10 ET
Summary
- Investors might find value in looking beyond the crowded tech sector for investment opportunities.
- Ecolab is a high-quality business with a strong sales history and persistent FCF production.
- Valuations are obscenely high and difficult to grow into, while the capital structure is negatively skewed for the equity holder.
Investment outlook
Investors might be well served looking beyond the highly crowded tech sector for investment opportunities over the coming 12-24 months. US Q3 earnings were exceptionally strong, with growth projections intact for the majority of sectors. Moreover, the Fed's decision to pause its hiking cycle changed the market's character to a risk on attitude, filled with plenty of buying initiative.
After an aggressive rally off its October lows, Ecolab ( ECL ) has flown onto our radars for thoughtful analysis using economic principles.
My judgement on ECL is that it is a high-quality business that will continue to grow sales above long-term GDP and leverage up earnings through its healthy balance sheet and capital structure, as it has done for the last nearly 100 years.
The company, founded in 1924, provides hygiene and infection prevention solutions to a range of industry in >170 markets globally. It operates across 3 segments, (i) global industrial, (ii) global institutional, and (iii) specialty and global Healthcare + lifesciences. Each are split into various sub-segments, building the firm's portfolio. Q3 '23 sales were $3.96Bn, on earnings of $1.54/share ($6.16 annualized) against $27.30 in net capital per share, 16% return on equity.
Figure 1.
ECL trades at a market value well above the earnings and investor capital employed in it, by compounding profits on its underlying assets at attractive rates. Earnings produced on equity are satisfactory—but highly leveraged. Buyer beware.
For instance:
(1). Roughly 35% of the company's assets are equity-financed, with an equity multiplier of 2-3x since 2020,
(2). Equity comprises ~50% of investor capital employed into the business.
The net effect of this produces a highly valued company—$63Bn enterprise value as I write. Compared to the earnings and assets of the business, this is a markedly high valuation.
ECL sells at 37x next year's earnings , 7x net asset value on a 4% trailing cash flow yield at the time of writing. For this, one receives 16% return on equity, ~$6.00 in TTM FCF/share (3% yield) and forward earnings growth of ~9-10%, with dividends yielding 1% on $2.12/share (Figure 2a).
These frictional issues around valuation could certainly impede investor returns in my estimation. Based on the factors outlined here today, I rate ECL a hold on valuation grounds.
For reference, the company's key investment statistics are noted in Figure 2.
Figure 2.
Figure 2a. ECL Dividend history, 2012–date
Critical investment facts supporting thesis
Valuations aside, there is a constructive business underneath ECL's economic bonnet. This is a profitable business with durable free cash flow and return on investor capital. It has cash-generative model because it is a high margin, capital efficient company.
The following points weigh in positively to ECL's economic prospects.
(1). Materials primed to deliver based on growth/value axis
Q3 earnings were strong with communication services, financials and tech leading the contribution of S&P 500 index earnings growth (Figure 3). Materials were a negative 60bps contribution to the index, which exhibited weighted average earnings growth of 6.3% from Q3 2022.
Figure 3.
Figure 3a.
Conversely, materials hold a 10% contribution to the index's projected growth in the next 12 months, but make up only 2% of its current market weighted value (Figure 4). Similarly, industrials make up 16% of projected forward growth with 8% weighting in the index, making both sectors excellent places to start in top-down security selection. Measuring the share of projected earnings growth against current index weight, materials looks to offer interesting value.
Figure 4.
(2). Earnings highly leveraged against equity
The company routinely earns about 15–16% on the net capital required to run its business. As seen in Figure 4, the leverage impact is pronounced. Total assets are only 35% equity financed, and the multiplier on ROE averaged 2–3x since 2020. Equity holders enjoy 5-6% return on equity capital after the adjustment. ELC is below the watermark, with cash currently at 4–5%.
Figure 4.
The following critical insights are also relevant:
- The company trades at a substantial premium to the capital employed and put at risk in its business. Investors will pay 7x above book value to buy ECL today, or 3.8x the firm's underlying assets.
- ECL employed an additional $8.20/share of capital into underlying assets to earn another $1.28/share after-tax ($4.32/share), thus compounding earnings at an incremental rate of 15.6% on new capital. Roughly $53/share of investor capital is employed into the business, of which 51% is equity-linked.
- The earnings received—noted in Figure 5—are stable since 2021, returning 15-16% on equity as mentioned earlier, or 6-8% on total capital. As a proportion of total return, the equity-linked return has ranged between 3-4% since 2021—marginal claim on the residual earnings of the company.
Figure 5.
Of course, the investor's returns are not as high as the company's returns, because of 1) the capital structure, as discussed, and 2) one must buy ECL at a substantial premium to underlying equity capital. For instance:
- The company trades at 7x the net asset value of $27.34/share as I write,
- It is expected to earn $5.20/share on ~$28/share of equity capital this year, or 18.6% ROE (5.2/28 = 18%).
- Paying 7x this reduces the investor return to 2.6% (5.2/(7x28)= 2.6%).
Subsequently, the fundamental economics driving investor returns are skewed to the flatter side, in my opinion.
This is evidenced in Figure 6. Linear regression on consensus estimates projects 15-17% bottom-line growth out to 2026. Paying 7x net capital, one receives 2-4% rate of return. So one buys 15-17% growth but receives 2-4% comparing earnings against capital required to produce them. In my view, this is not a fair and reasonable value proposition.
Figure 6.
(3). Cash generative business cycle driven by margins
ECL has a cash generative operating cycle because it is a reasonably high-margin, capital efficient business. It turns over underlying assets ~1x on average with post-tax margins of 12–13%, returning 10–12% on capital at risk in operations (Figure 7).
The net effect is a firm throwing off $1–$2Bn in free cash flow each rolling TTM period as:
(1). Cash flowing into productive assets + inventory that is spinning back after-tax profits,
(2). It also maintains relatively low net working capital investment, with inventory and NWC of $1.5Bn on trailing sales of $15Bn.
Figure 7.
Consequently, FCF is stable but reasonably low at $6-8/share on $192/share in market value. It has produced $56/share in cumulative FCF since 2020, 29% yield of today's value. Part of the headwind is the lack of reinvestment opportunities. Being a mature-phased firm, opportunities to deploy surplus capital at a net present value above the hurdle rate are low. Hence, the dividends + buybacks, but the propensity for ECL to compound intrinsic value is hindered on this view in my opinion.
Figure 8.
Valuation and conclusion
The stock also sells at 37x forward earnings and 30x forward EBIT, 137% premium to the sector each respectively. To grow into these multiples is dream-like in my opinion. I cannot advocate buying any security over a reasonably time frame at 37x earnings for 2-3% in adj. return on equity. On this ground alone I rate the firm a hold. I would not be interested until a pullback closer to the sector multiple of 15x.
You do have a profitable, FCF-positive here in ECL, however. Capital structure and valuations let it down in the investment debate in my estimation. The company's FCF/share against changes in market value are seen in Figure 9. Its market value has not tracked the firm's FCF well, because opportunities to redeploy this cash are low, as mentioned earlier. As such, a hold rating is supported in my opinion.
Figure 9.
In short, after rigorous analysis of the facts, there are two critical factors that prevent my buy recommendation today. One is the firm's capital structure. Only 35% of assets are equity financed and the business ROE is leveraged 2-3x, meaning only ~50% of capital employed in the business is equity-linked. Paying 7x net asset value also reduces the investor returns a considerable amount, leaving a negligible value gap from today's market value in my opinion. Net-net, rate hold.
For further details see:
Ecolab: Paying 7x Net Assets Pushes Investor ROE To 2.5%