By The Valuentum Team
Ecolab's net debt has ballooned as a result of its acquisition of Nalco.
Ecolab's (NYSE:ECL) merger with Nalco created the global leader in water, hygiene and energy technologies that provide safe food and protect clean water and healthy environments. The company is known for innovation and consistently releases significant new product introductions. It owns 6,300 patents.
Frankly, there's a lot to like about Ecolab. The company has a 15% annual earnings-per-share growth objective. Its strong product margins, generally stable end markets, and relatively low capital requirements result in strong free cash flow generation. Though its net debt has ballooned as a result of acquisitive behavior, the balance sheet remains investment grade.
Every company is tied to the economic environment to some degree, but Ecolab's products fulfill basic global needs for food, water, energy and healthcare. We think this makes the company more resilient during times of economic hardship. Though the road will inevitably be bumpy, Ecolab's goal of $20 billion in revenue by 2020 is achievable.
Perhaps more than most companies, Ecolab's success depends on its ability to continue to identify, develop and commercialize innovative, high value-added products for niche applications. The firm continues to deliver.
Ecolab cut its earnings forecast for 2015 twice during the course of the year. While we cannot say that management does not have a solid handle on its business, it does hurt our confidence in the firm's long-term growth targets.
Note: Ecolab's annual dividend yield is below average, offering a ~1.3% yield at recent price levels. We prefer yields above 3% and generally don't include firm's with yields below 2% in our dividend growth portfolio. But is the firm's payout poised for material growth? Let's take a look.
Ecolab's multi-decade long history of dividend increases lands it on the coveted Dividend Aristocrat list. Strong product margins and stable markets have resulted in strong operating cash flows in recent years. Along with that, moderate capital expenditures have helped generate an average of ~$875 million in free cash flow over the past three years. The demand for safe food, clean water, and healthy environments is not cyclical, making Ecolab's business not as susceptible to economic cycles. This stability allows it to generate consistent earnings and free cash flows every year and fuel dividend growth, which we expect to continue.
While strong free cash flows have been the backbone to Ecolab's ability to grow its dividend, a large net debt position of ~$6.5 billion prevents its Dividend Cushion ratio from being truly outstanding. It has a target net debt-to-EBITDA ratio of approximately 2x which is a solid target, but a recent build in long-term debt will make it harder to realize that target leverage ratio. Nevertheless, the company boasts an investment grade credit rating. Ecolab's Global Energy segment has been growing slower than expected due to the downturn in the crude oil market, showing that the firm is not totally immune to economic cycles, but other segments have been able to compensate for the weakness and maintain its dividend health.
From the Comments Section: How to Interpret the Dividend Cushion Ratio -- A Ranking of Risk
As for how to interpret the Dividend Cushion ratio, itself, it is a measure of financial risk to the dividend, much like a credit rating is a measure of the default risk of the entity. Said differently, a poor Dividend Cushion ratio of below 1 or negative doesn't imply the company will cut the dividend tomorrow, no more than a junk credit rating implies a company will default tomorrow. That said, the Dividend Cushion ratio does punish companies for outsize debt loads because in times of adverse conditions, entities often need to shore up cash, and that means the dividend becomes increasingly more risky.
We think investors should look at a variety of different metrics in assessing the sustainability of the dividend. Because the Dividend Cushion ratio is systematically applied across our coverage, it can be used to compare entities on an apples-to-apples basis. Dividend payers with significant free cash flow generation and substantial net cash on the balance sheet often register the highest Dividend Cushion ratios, as they should. These companies have substantial financial flexibility to keep raising the dividend.
We think the safety of Ecolab's dividend is good. Please let us explain.
First, we measure the safety of the dividend in a unique but very straightforward fashion. As many know, earnings can fluctuate, so using the payout ratio in any given year has some limitations. Plus, companies can often encounter unforeseen charges, which makes earnings an even less-than-predictable measure of the safety of the dividend. We know that companies won't cut the dividend just because earnings have declined or they had a restructuring charge that put them in the red for the quarter (year). As such, we think that assessing the cash flows of a business allows us to determine whether it has the capacity to continue paying dividends well into the future.
That has led us to develop the forward-looking Dividend Cushion™ ratio, which we make available on our website. The measure is a ratio that sums the existing net cash a company has on hand (on its balance sheet) plus its expected future free cash flows (cash flow from operations less capital expenditures) over the next five years and divides that sum by future expected cash dividends over the same time period. Basically, if the score is above 1, the company has the capacity to pay out its expected future dividends and the expected growth in them.
As income investors, however, we'd like to see a ratio much larger than 1 for a couple of reasons: 1) the higher the ratio, the more "cushion" the company has against unexpected earnings shortfalls, and 2) the higher the ratio, the greater capacity a dividend-payer has in boosting the dividend in the future. For Ecolab, this ratio is 1.7, revealing that on its current path the firm should be able to cover its future dividends and growth in them with net cash on hand and future free cash flow.
Dividend Cushion Ratio Cash Flow Bridge
The Dividend Cushion Cash Flow Bridge, shown in the graph below, illustrates the components of the Dividend Cushion ratio and highlights in detail the many drivers behind it. Ecolab's Dividend Cushion Cash Flow Bridge reveals that the sum of the company's 5-year cumulative free cash flow generation, as measured by cash flow from operations less all capital spending, plus its net cash/debt position on the balance sheet, as of the last fiscal year, is greater than the sum of the next 5 years of expected cash dividends paid.
Because the Dividend Cushion ratio is forward-looking and captures the trajectory of the company's free cash flow generation and dividend growth, it reveals whether there will be a cash surplus or a cash shortfall at the end of the 5-year period, taking into consideration the leverage on the balance sheet, a key source of risk. On a fundamental basis, we believe companies that have a strong net cash position on the balance sheet and are generating a significant amount of free cash flow are better able to pay and grow their dividend over time.
Firms that are buried under a mountain of debt and do not sufficiently cover their dividend with free cash flow are more at risk
of a dividend cut or a suspension of growth, all else equal, in our opinion. Generally speaking, the greater the 'blue bar' to the right is in the positive, the more durable a company's dividend, and the greater the 'blue bar' to the right is in the negative, the less
durable a company's dividend.
Dividend Cushion Ratio Deconstruction
The Dividend Cushion Ratio Deconstruction, shown in the graph below, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Ecolab's numerator is larger than its denominator suggesting strong dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Please note that to arrive at the Dividend Cushion ratio, divide the numerator by the denominator in the graph below. The difference between the numerator and denominator is the firm's "total cumulative 5-year forecasted distributable excess cash after dividends paid, ex buybacks."
Now on to the potential growth of Ecolab's dividend. As we mentioned above, we think the larger the "cushion" the larger capacity the company has to raise the dividend. However, such dividend growth analysis is not complete until after considering management's willingness to increase the dividend. To do so, we evaluate the company's historical dividend track record. If there have been no dividend cuts in the past 10 years, the company has a nice dividend growth rate, and a solid Dividend Cushion ratio, we characterize its future potential dividend growth as excellent, which is the case for Ecolab.
Because capital preservation is also an important consideration to any income strategy, we use our estimate of the company's fair value range to assess the risk associated with the potential for capital loss. In Ecolab's case, we currently think shares are overvalued, meaning the share price falls above our estimate of the fair value range, so the risk of capital loss is high (our valuation analysis can be found by downloading the 16-page report on our website). If we thought the shares were undervalued, the risk of capital loss would be low. Please view our website for its valuation assumptions.
Wrapping Things Up
Ecolab has some ambitious long-term targets, including $20 billion in revenue by 2020 and 15% annual earnings-per-share growth. However, the firm cut its 2015 earnings forecast twice during the course of the year, which hurts our confidence in its ability to live up to these goals. Nevertheless, we feel its dividend, while having a relatively small yield, is on solid ground thanks to strong free cash flow generation. Its debt level may be worth watching, as it has risen due to acquisitions, but we like the firm's target leverage ratio. All things considered, Ecolab's small yield and overpriced shares are not enticing to us by any means.
Breakpoints: Dividend Safety. We measure the safety of a firm's dividend by adding its net cash to our forecast of its future cash flows and divide that sum by our forecast of its future dividend payments. This process results in a ratio called the Dividend Cushion. Scale: Above 2.75 = EXCELLENT; Between 1.25 and 2.75 = GOOD; Between 0.5 and 1.25 = POOR; Below 0.5 = VERY POOR.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
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.