Is Ecolab Stock a Buy?

Food safety, hygiene, and clean water company Ecolab (ECL -0.09%) continues to be a stock keenly contested by bulls and bears. On the one hand it's a great business with a high degree of recurring revenues and it obviously has lines of businesses that are going to benefit from an increased awareness around the need for clean environments. On the other hand, some of its key end markets will be challenged for some time. Let’s take a look at what's going on.

Ecolab's near-term challenges

I'll cut straight to the chase. The key question centers on Ecolab's exposure to the hard hit restaurants and lodging sectors -- reported in the institutional segment. The matter can be easily seen by a break out of sales in the third quarter, with the company's institutional sales reporting a dramatic decline in sales and income. More on that in a moment.

Turning to Ecolab's industrial segment, sales growth was still negative in the quarter, but operating income increased strongly on the back of pricing increases and cost cuts. Looking ahead, industrial based sales are likely to improve as sites open up again, albeit with near-term weakness as the second wave of COVID-19 hit the global economy.

Ecolab investors will be hoping restaurants reopen and stay in business. Image source: Getty Images.

Finally, the company's global healthcare and life sciences sales continue to be boosted by COVID-19, although these kind of growth rates are obviously not sustainable especially as the vaccine is likely to accelerate the natural process of herd immunity in the community.

Data source: Ecolab presentations. Figures are non-GAAP adjusted. YOY= year over year.

Ecolab's global institutional segment

Naturally, the segment's prospects were discussed at length during the third-quarter earnings call. The key questions, to which nobody can definitively answer right now, is over the pace of the recovery in revenue from restaurants/lodging/hospitality and where will the industry go from here?

To this end CEO Douglas Baker noted on the third-quarter earnings call that "over 90% of restaurants in the U.S. were open by the end of third quarter, running at a roughly 55% capacity rate." Clearly, it's going to take time for the restaurant industry to recover. Indeed, Baker went on to outline that " Institutional is obviously ground zero for COVID, and there is going to be some knock-on effects for a period of time." However, on a brighter note he expressed confidence that restaurants would " recover a lot quicker" than lodging which is expected to take a "couple of years to recover."

Ecolab's products help keep food production clean. Image source: Getty Images.

Clearly, Baker and Ecolab's investors are hoping that the lodging and restaurant industries return to the pre-pandemic status quo over time. Consequently, Ecolab's institutional sales will recover and the current level of revenue and earnings are seen as being artificially depressed.

Putting it all together the investment case for Ecolab is based on the idea that people will go back to dining out in restaurants and visiting hotels over time so Ecolab's institutional sales will recover, and industrial sales will mark a sharp recovery in 2021 as the economy opens up.

Two concerns

There are two key, and connected, arguments against the bullish view on Ecolab:

• The extended period of stay-at-home measures could create some kind of marginal shift in behavior whereby consumers are more minded to eat at home than previously.
• Ecolab's valuation doesn't give much room for error, so if the above argument is true then the downside is significant.

Put another way, the upside to the stock is limited and the downside is significant. A quick snapshot of commonly used valuation metrics shows that Ecolab is not cheap compared to its historical valuation.

Data by YCharts

While it's true that 2020 is a uniquely bad year, and that Ecolab probably deserves a higher rating because it separated its upstream energy focused business, ChampionX, in 2020 it's still very hard to make the case that the stock is cheap on an absolute basis. For example, based on analyst forecasts Ecolab will trade on 41 times earnings at the end of 2021. 

A stock to buy?

All told, Ecolab is an attractive business, but investors will need to see some hard evidence of a recovery in dining out and hotel visits before they feel fully confident in buying into the stock at these levels. Even if you think a full recovery is likely, investing is also about protecting against the risk of being wrong and a stock trading on 41 times forward earnings isn't usually one with a lot of downside protection built into it.