It’s rare to find a company that’s a no-brainer. Some business models are just so lucrative and well-protected that the question isn’t about whether you should invest, it’s about the price at which you should enter.
One such company is an all-time favorite dividend appreciation stock – Ecolab Inc (ECL).
If you haven’t already heard of the company or its products you’re not alone. Most investors have never come across Ecolab stock, but there’s a good chance they’ve used one of their products without without realizing it.
Here’s a closer look at a special Dividend Aristocrat with a substantial pedigree, some famous backers, an irrefutably good service, and a considerably rosy outlook for the future:
Ecolab is the sort of company that’s happy to fly under the radar. The company has been around for 90 years and was listed on the stock exchange in 1957, and is a part of the famous Dividend Aristocrats Index.
The company is built around one key goal – keeping things clean.
Merritt J. “M.J.” Osborn started the company in 1923 as Economics Laboratory. The only product it sold was a cleaning agent that helped clean hotel carpets. A few years later the company expanded the portfolio with a new dishwasher soap – Soilax.
Over the decades the company has grown through acquisitions and new products. Almost of all these cleaning and hygiene products are backed by patents that protect the formula. This means the products are not just highly effective but the company can actually charge more for this superior product since no one else on the market can replicate it. That’s a considerable competitive moat.
To expand their competitive moat the company signs long-term contracts with large industrial businesses to supply all their safety, cleaning, and energy needs. This means 90% of the income generated each year is recurring.
Perhaps one of the most interesting things about this company is the fact that it makes up a significant portion of Bill Gate’s personal portfolio. We talked about all the dividend stocks in Bill Gate’s portfolio last week and Ecolabs is nearly 3% of his portfolio. The Gates family owns 25% of the entire company, making them the largest shareholders.
That’s a significant recommendation from one of the smartest and richest businessman on the planet. Gates has a professionally managed portfolio with some high-quality companies that pay a substantial dividend. Part of the allure is the company’s business model.
Ecolabs has a clever way to generate value. It spends a lot of money creating new patents for cleaning solutions and specialty chemicals. Once these formulas are secured the company designs a product and hires people to go out selling to businesses of all sizes.
Of the 47,000 employees at the company, nearly 25,000 face customers and help with maintaining relationships. This salesforce is tasked with taking care of the client’s every need and upselling wherever possible. So, if a business signs a long-term contract for kitchen cleaning solutions, the relationship manager will also try to get them signed up for carpet, toilet, and window cleaning solutions. This means there is a lot of overlap in customers and a lot of repeat business from high-value clients.
More than one hundred suppliers across the globe interact daily with thousands of potential and current customers. An ongoing cycle of cross-selling and upselling keeps the business swimming in cash flow.
When the company isn’t investing in research and development to launch new cleaning or energy products, it’s acquiring businesses to augment the firm’s services. The company recently completed two key acquisitions that allows it to expand the footprint in industrial products and the energy market. Nalco (2011 – $8 billion) and Champion Technologies (2013 – $2 billion) were both completed to help the business expand into related, but untapped fields.
So, what makes Ecolab an attractive, long term , dividend appreciation stock? Here’s a closer look at the company’s finances:
Ecolabs is massive with over 47,000 employees, $13 billion in revenue and nearly $1.2 billion in net profit.
The profit margins are slim but stable. Operating margins have fluctuated between 10% and 14% in recent years. Over time, the company aims to grow earnings at a steady pace of 15% a year and is trying to reach return on invested capital of over 20%.
Revenues are split between three different segments. Global industrial, Global institutional, and energy made up 30-35% of revenues each. That means the business is nearly neatly divided between these three segments. 5% of revenues come from other, unrelated sources.
Return on equity is a stunning 17.8%, but that could be because of the financial leverage on the books. The company has a financial leverage ratio of 2.66, which means it has $2.66 in assets for every dollar in equity. The debt-to-equity ratio is nearly 0.86. That’s a significant amount of debt.
However, the company generates stable and reliable cash flows to handle the debt. The interest coverage ratio last year was a decent 6.85.
Although the dividend yield isn’t high (at barely 1.08%) the company has paid a dividend for the past 79 years and has been growing consecutively since 1986. The company has been paying less than one-third of earnings in the form of dividends, which means the payout ratio is low and there’s room to grow.
Over the past ten years the dividends have grown at an annual compound rate of 14%, which is considerably higher than the S&P 500 average.
The expected dividend this year is $1.48.
Considering how stable the earnings and dividends are, a traditional dividend discount method could be the best way to value Ecolabs.
The expected dividend this year is $1.48, the growth rate is expected to be 6% (much lower than the 15% in the past ten years), and the weighted average cost of capital (WACC) is estimated at 7.5%.
Putting those figures and estimates together, we arrive at the following:
Value = $1.48 x (1.06)/ (0.075 – 0.06)
The intrinsic value, based on these estimates, is $104.58. That means the current market price is 28% higher. That premium is far too high to justify the investment. Perhaps a look at the multiples is a better option for this company.
Ecolab trades at 31x price-to-earnings, which is substantially higher than both the S&P 500 and the industry average. Similarly, price-to-sales and price-to-cash flow is higher than average, while dividend yield is below average.
Yet another way to look at this is to see what price Gates paid for his stake. Bill Gate’s long-time money manager Michael Larson, who is a notorious value investor, is the money manager who handles the personal portfolio alongside the Gates foundation’s portfolio. In April, 2016, the portfolio increased the stake in Ecolabs from 10% to a whopping 25% of the company. He bought nearly half a million more shares in the business at an average price of $105 per share.
Now, assuming the purchase price is at a reasonable discount to fair value (say 15%) the fair value could be somewhere between $120 to $140. Even by this measure, the stock is still fairly valued and not worth investing in just yet.
From almost all angles, the stock looks overbought. It’s at a fairly high premium to a justified price and that makes this a dividend appreciation stock worth watching but not worth buying now.
There’s no doubt this is an excellent business. Ecolabs is a company that’s managed to survive and thrive for nearly a century. It is also a dividend appreciation stock like no other. Ecolabs has a global base of clients that provide it with regular cash flows and long-term earnings stability. It’s managed to pay a dividend for more than seven decades. It has managed to grow dividends for nearly half a century. That places it firmly in the Dividend Aristocrat basket.
The stock is also a firm fixture in the Bill Gates portfolio, which is always a good sign.
However, the stock is overpriced. At the moment, the stock trades at a considerable premium to both the intrinsic value and the average industry multiple. It’s worth keeping an eye on this stock and buying when there’s a correction.