During volatile times, investors seek shelter and safety in quality companies that can weather a crisis. This strategy, however, can be problematic at times, if quality companies are bought at too high of a valuation. This can lead to sub-par investment returns over the long run, even if an investor feels that they can sleep-well-at-night in the short term. The company that I’m focused on today, Ecolab (ECL), is one such company that is trading at a premium valuation. In this article, I evaluate this company from a risk vs. reward perspective, and make a recommendation, so let’s get started!
(Source: Company website)
A Look Into Ecolab
Ecolab is a leading global provider of water, hygiene, and infection prevention solutions. Its solutions and data-driven insights help its customers advance safety, maintain safe environments, and optimize water and energy use. The company was founded nearly 100 years ago, with Soilax, a dishwashing detergent used in commercial dishwashers, as its first product. Today, Ecolab generates over $14 billion in annual sales, and the company’s products have a wide range of uses in the food, healthcare, hospitality, and industrial markets. It is also a member of the Dividend Aristocrats group through its 34-year track record of annual dividend increases.
Like many other companies, COVID-19 has been a key risk factor for Ecolab, as demonstrated by the declines in revenue and EPS of -15% and -49% YoY, respectively, during the latest quarter. Looking forward, I see further headwinds for the company, as its restaurants, lodging, and industrial markets have been among the worst hit. This is supported by a recent report from OpenTable, which estimated that as many as a quarter of all restaurants will shut their doors during this pandemic.
However, I do see Life Sciences and Healthcare as continuing to be bright spots for the company, as pharmaceutical development and hospitals become increasingly reliant on Ecolab’s products for their mission-critical work. Considering all factors, I believe that Ecolab will have a difficult time growing its revenue for the remainder of this year, and into next year, as the net effect of both the positives and negatives will largely cancel each other out.
Meanwhile, the current market price does not appear to reflect the currently difficult operating environment, as the shares are currently trading at a high P/E ratio of 41. While the high P/E ratio is partly affected by recent EPS difficulties, I still see the current price as being stretched, even without a depressed EPS. As seen below, the normal P/E for this stock is 26, and without the difficulties from COVID-19, this stock should trade in the ~$165 range based on normal P/E. With a challenging earnings environment due to COVID-19, this stock should actually trade somewhat lower than $165 per share.
(Source: F.A.S.T. Graphs)
In addition, I also wanted to see what the PEG ratio would be under certain assumptions. Based on the 2010 to 2019 (pre-pandemic) EPS figures in the F.A.S.T. Graph above, I calculated an annualized EPS growth rate of 11.2%. Then, I apply the following figures into the formula below:
- Price: $194.71
- EPS: $4.73 (average of 2020 and 2021 estimates from F.A.S.T. Graph)
- EPS Growth Rate: 11.2
The end result is a PEG ratio of 3.7, which implies that the stock is deep in overvalued territory. In addition, I was also being generous, as I applied a pre-pandemic growth rate, and an EPS that was the average of 2020 and 2021. Had I applied the 2020 expected EPS into the calculation above, the PEG ratio would have been much higher at 4.2.
Lastly, I believe continued double-digit EPS growth will be harder to come by, as revenue grew at a CAGR of just 2.4% during the 2015-2019 (pre-pandemic) time frame. This makes sense, as Ecolab is a mostly mature business, and at some point, I would expect the slow revenue growth to be reflected in slower EPS growth as well.
(Source: Created by author based on company financials)
Turning to analyst estimates, as seen on the purple line, it appears that the consensus recommendation has steadily approached a Hold rating since the beginning of the year. Additionally, the current price target of $193 sits slightly below where the shares are trading at today.
Ecolab is a global leader in providing water, hygiene, and infection prevention solutions to a wide-range of industries. While the company has a wide-moat business and a strong track record of EPS growth, I see the current valuation as being tilted more towards risk than reward. This is demonstrated by the near-term headwinds that COVID-19 has brought to the business. Longer term, I believe EPS growth could be slower than what the company has seen in the past, as Ecolab is a largely mature business with slow revenue growth.
I believe the currently high share price valuation is not fully reflective of these aforementioned risks. While I wouldn’t necessarily recommend anyone to sell shares that they have bought at lower prices, I don’t believe the share price is attractive for new investment dollars. As such, I have a Hold rating on the shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.