2023-09-18 01:30:25 ET
Summary
- Ecolab stock has offered a total return of 17% since my previous article, eight months ago, with potential for further upside.
- The company, a global leader in water, hygiene, and energy technologies, has promising growth prospects thanks to its R&D capabilities and an expanding market.
- Analysts expect ECL to grow its earnings per share by 15-18% per year during 2024-2026, indicating an attractive growth trajectory.
In 2021, I recommended avoiding Ecolab ( ECL ) due to its rich valuation back then. After that article, the stock plunged 33% until early this year due to excessive cost inflation and its rich initial valuation. At that point, I recommended buying Ecolab, as the valuation of the stock had become attractive and I was expecting cost inflation to moderate. Indeed, since my second article, cost inflation has abated and thus the stock has offered a total return of 17%, in just eight months. Given the steep rally of the stock, some investors will be tempted to take their profits. However, the stock still has significant upside potential and hence investors should not take their profits yet.
Business overview
Ecolab is the global leader in water, hygiene, and energy technologies and services, with approximately 47,000 associates in more than 170 countries. It offers water treatment and process applications to companies in the food & beverage, manufacturing, oil and chemical industries as well as services to restaurants, hotels, hospitals and retailers.
The company has more than 1,200 scientists who are focused on developing innovative products in order to reduce the costs of the customers of the company and their use of natural resources. The exemplary R&D department of Ecolab has created more than 9,000 patents. It is thus easy to understand why Ecolab is the global leader in its business.
Ecolab was hurt by the surge of inflation to a 40-year high last year, which resulted from the war in Ukraine and the sanctions of the U.S. and European Union on Russia. Due to the Ukrainian crisis, Ecolab experienced exceptionally high cost inflation last year and thus it incurred a 4% decrease in its earnings per share.
A 4% decrease in the bottom line during a fierce downturn is certainly benign, but it is important to keep in mind that the company had grown its earnings per share consistently, at double-digit rates before the pandemic and the Ukrainian crisis. More precisely, Ecolab grew its earnings per share at a 10.9% average annual rate between 2011 and 2019. It was then hurt by the pandemic in 2020, it partly recovered from the pandemic in 2021 but it then faced the strong headwind of 40-year high cost inflation, which took its toll on the operating margins of the company.
Fortunately, the worst seems to be behind Ecolab in reference to inflation. Thanks to the drastic response of the Fed and other central banks around the globe, inflation has decreased significantly this year. Inflation in the U.S. has decreased from a 40-year high of 9.2% last summer to 3.6% now while inflation in Europe has decreased from 8.6% last summer to 5.5% now.
The moderation of inflation is clearly reflected in the results of Ecolab. In the second quarter, the company grew its organic sales 9% over the prior year's quarter thanks to healthy volumes and material price hikes, which more than offset the effect of cost inflation. As a result, Ecolab grew its earnings per share 13%, from $1.10 to $1.24, and exceeded the analysts' estimates by $0.03.
Even better, management expects business momentum to accelerate in the second half of this year. It expects sustained improvement in volumes sold and an expansion of gross margins by 150-200 basis points. As a result, Ecolab expects to grow its earnings per share by 12-19% in the third quarter and maintain its strong momentum in the fourth quarter. Analysts agree on the outlook of the company, as they expect it to grow its earnings per share by 14% this year.
Moreover, now that Ecolab is recovering from the Ukrainian crisis, it has promising growth prospects in the upcoming years. Thanks to its unparalleled R&D department and its scale, it can continue gaining market share from smaller companies, which cannot match the economies of scale of Ecolab.
It is also important to note that the addressable market of the company is growing at a fast pace.
Ecolab: Growth of Addressable Market (Investor Presentation)
As Ecolab has a market share of only 9% and its industry is highly fragmented, the company can continue growing its market share for years. Given the growing size of its addressable market, Ecolab has promising growth prospects. Indeed, the company expects to return to its historical double-digit growth of earnings per share in the upcoming years.
Analysts agree on the exciting growth potential of Ecolab, as they expect the company to grow its earnings per share by 15-18% per year during 2024-2026, from $5.11 in 2023 to $8.06 in 2026. This is certainly an attractive growth trajectory.
Valuation - Potential Upside
Thanks to its consistent and reliable growth trajectory, Ecolab has always traded with a premium valuation. To provide a perspective, the stock has traded at an average price-to-earnings ratio of 32.3x over the last decade.
The stock is currently trading at a forward price-to-earnings ratio of 34.8x . While one can reasonably expect the stock to trade around its historical average valuation level in 2026, it is prudent to assume a future price-to-earnings ratio of 27.0 in order to be on the safe side. If Ecolab trades at this earnings multiple in 2026 and meets the aforementioned analysts' estimates of $8.06 in 2026, it will trade at $218 (=27*8.06) in that year. Such a price target implies upside potential of 22% over the next three years. If the 1.2% dividend is included, the stock can offer a total return of 26% over the next three years or 8.0% per year on average.
An average annual return of 8.0% is attractive but not impressive. However, it is important to note that we have assumed a strong headwind from valuation for the next three years, as we have assumed that the price-to-earnings ratio will deflate from 34.8x to 27.0x. If the earnings multiple of the stock decreases much less than we have assumed, e.g. from 34.8 to the 10-year average of 32.3, the total annual return of the stock will become 14.7%.
Risk
As Ecolab has finally recovered from the downturn caused by excessive cost inflation, the primary risk of the stock is the adverse scenario of a severe recession. In such a case, the company is likely to experience a significant deceleration in its business, as reduced economic activity will take its toll on the sales and pricing power of the company.
However, it has proved impossible to time a recession. Those who remain on the sidelines due to abstract fears of a recession are likely to forgo the rewarding long-term returns of Ecolab. Moreover, central banks are doing their best to cool the global economy via high interest rates, but the global economy remains somewhat heated. Whenever the first signs of a recession show up, central banks are likely to become accommodative. Therefore, even if a recession shows up, it is not likely to be prolonged.
Ecolab has repeatedly proved its resilience to recessions, as it has always emerged stronger from such downturns. Thanks to its dominant business position and its strong balance sheet (net debt to market cap is only 20% and interest expense consumes only 18% of operating income), the company is likely to easily endure any economic downturn.
Final thoughts
The surge of cost inflation took its toll on the performance of Ecolab last year, but the company is now recovering strongly from that downturn. Despite the rally of the stock of Ecolab this year, the double-digit earnings growth of the company is likely to compensate patient investors for the initial premium they pay. Overall, the stock is still likely to highly reward investors with a long-term perspective from its current price.
For further details see:
Ecolab Still Has Significant Upside, Despite Its Rally This Year