Jensen Investment Management: Company Highlight Series – Ecolab Inc. (ECL)
Long-Term Value Creation Trumps Short-Term Headwinds
First purchased in late 2005, Ecolab (ticker: ECL) is a longtime Fund holding and we believe a prime example of the relationship between our investment philosophy and long-term value creation.
Jensen Investment Management – Ecolab: Investment Thesis and Value Creation
Ecolab dominates the global market for sanitation chemicals used by institutional customers, such as hotels, school districts and restaurants. And, as a result of recent acquisitions, the company is now a top competitor in the worldwide market for chemicals used in the oil and gas industry.
Our fundamental investment thesis on Ecolab is little changed from that of our initial investment. Importantly, our analysis indicates a stable business model characterized by recurring revenue. Specifically, we estimate approximately 90% of the company’s revenue comes from sales of disposable products, the majority of which are made under long-term contracts. Additionally, the company’s sales and service infrastructure is 3-4 times larger than that of any of its competitors and represents a powerful competitive advantage, in our opinion.
Ecolab’s business model has produced meaningful, long-term business- and shareholder-value creation. Over the ten-year period ending 12/31/15, the company produced annualized net income and EPS growth of 14.2% and 12.5%, respectively, while maintaining an average Return on Equity (ROE) of nearly 21%. Further, over this same time period, Ecolab shares produced an annualized total return of 12.2%, surpassing that of the S&P 500 index by more than 500 basis points.
More recently, however, the business and share price have come under pressure. Case-in-point, Ecolab was the leading detractor to Fund performance during the most recent quarter after the company announced relatively soft 2015 earnings and guided to 2016 results below consensus expectations.
Recent weakness has stemmed from the company’s Energy end market exposure. During the fourth quarter of 2015, sales from Ecolab’s energy-related businesses represented approximately 28% of total company sales and declined by nearly 14%, when measured on a constant-currency basis.
Given the recent collapse in oil prices, we were not surprised by the decline in this business. However, deeper analysis results in us remaining confident in our positive long-term view.
Activity in the energy market consists of three broad functions (in order of sensitivity to changes in oil prices): 1) Exploration, 2) Production, and 3) Refining. We estimate Ecolab’s exposure as follows: 67% Production, 22% Refining, and 10% Exploration. Across these businesses, they sell a broad spectrum of chemicals, including corrosion inhibitors, oil/water separators, and oil dispersants. We maintain a positive view on this business mix as it skews towards more stable Production and Refining activities.
Sales diversity within the company’s Energy segment mirrors diversity across the entire business. As mentioned, Ecolab’s energy business accounted for approximately 28% of sales in the most recent quarter. The remainder of the company’s sales were to customers in a wide array of industries including the hotel, restaurant, retail, food/beverage, manufacturing, water and pulp/paper industries. Sales to these end markets increased nearly 5% last quarter and have been relatively stable in the past.
Over the past ten years, the Fund’s 15.6% average annual turnover implies an average holding period of more than six years. To say that we are patient investors is somewhat of an understatement. For us, patience is a function of business value creation and we strive to look through short-term ‘speed bumps’ provided that they do not erode our long-term view.
Ecolab is presently a great example of this philosophy. While the company is no doubt facing some headwinds, we believe the business is structurally sound and is poised to grow and create value well into the future.