Ecolab: Hospitality Play In Hiding (ECL)

Introduction: The hotel industry is back from the dead. Baby Boomers looking for novel, high-end experiences on which to spend their disposable income have, for example, recently pushed shares of luxury hotel chain Starwood Hotels (HOT) to a 52 week high (to $63.64; stock is up 26% in last 12 months). As the demographics suggest, this is an attractive area in which to invest. Unfortunately, news of Baby Boomer wealth has already manifested across several mainstream media and priced itself into those stocks most benefiting from the aging population. One less conspicuous way investors can play the pickup in travel-related activities and higher hotel occupancy rates is by scooping up shares in companies who service hotel chains. Minnesota-based Ecolab (ECL) is one of those stocks.The $10B (market cap) provider of cleaning and sanitation services spit out over $4B in sales last year through its more than 22,000 employees. Here's our first take on the stock, on which we initiate coverage with a HOLD.

Description:Ecolab produces and sells cleaning products and services to institutional, hospitality, and industrial customers. The company's key products include detergent and pest-elimination products, among others. Ecolab's major customers are restaurants, hotels, and hospitals. The firm has a strong international presence (conducts operations in 70+ countries), with approximately 50% of sales coming from overseas.

Positive Considerations: In early March, Ecolab's most formidable rival, JohnsonDiversey, announced its exit from the domestic hospitality space, leaving Ecolab as the better known alternative for hoteliers and restaurant managers looking for that "one-stop" solution to all its cleaning/sanitizing quandaries. We think JD's departure should allow ECL to capture at least 50% of the available warewashing market. Should our optimistic scenario materialize, the boon to Ecolab's top line narrative could be great, indeed: once embedded in hotel kitchens, Ecolab's products tend to stay put: clients face high switching costs since those clients have to be trained to safely use ECL's product mix, on which Ecolab recoups a healthy double digit margin.

We also like the firm's diminishing debt load, "sell or don't eat" salesforce mentality, and customer retention rate north of 85%. Lastly, we note that infection control remains a hot theme on the Street, something we think will prop up shares at least through 2006. The firm has already made several key moves in this area: it recently struck a deal with meat company Hormel (HRL) and introduced a safety-enhancing product for poultry-related goods called the Octa-Gone. On June 16th, Ecolab bought a UK firm ($19M in sales) that produces contamination control agents for hospital/medical device "clean rooms." We look favorably upon these small, nimble transactions since they extend Ecolab's product reach without exposing the firm to integration risk overhang.

Risks: They are many, unfortunately. If the foodservice, hospitality, and travel industries bomb, Ecolab's top line will catch a black eye. Management has done a decent job paring down debt, but we add that Ecolab's debt load remains roughly 11 x what the firm holds in cash. Raw material costs, another cloud in ECL's horizon, could further dampen share appreciation. The light at the end of the tunnel? Ecolab's in a buying mood and using acquisitive growth to slowly exploit economies of scale, exercise cost control measures, and augment leverage among its suppliers.

Valuation: At 6 x book, 32 x trailing earnings, and 24 x forward earnings, Ecolab is by no means cheap. Based on the 15% earnings growth that we expect ECL to cough up in 2007, we conclude that Ecolab is fairly overvalued, but worth holding onto. Our target P/E range for the stock, based on public comparables, remains 25 x current year estimates. With that, we arrive at our $35 fair value estimate on Ecolab shares. Albeit slightly mispriced, we believe Ecolab – a large cap play on disease-related hysteria and a healthy hospitality market -- remains an attractive name. On any weakness, we'd easily add Ecolab to a secular growth, risk-tolerant portfolio.

ECL 1-yr chart: