A Good Company Like This Retains Customers

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Ecolab (NYSE: ECL) operates in four business segments: Global Institutional, Global Industrial, Global Energy and Other.

The Global Institutional segment comprises of its cleaning and sanitizing solutions for dish washing equipment, restaurants and grocery chains; its hygiene and disinfection solutions for the medical industry.

Cleaning and sanitation solutions with respect to food processing, water treatment solutions for industrial markets, and pulp processing solutions are part of Ecolab's Global Industrial segment. 

Ecolab's Global Energy segment supplies process chemicals to the upstream oil exploration & production industry and water treatment solutions in the downstream refining process. 

Pest elimination services and other maintenance services related to foodservice equipment are categorized under the Other segment.

‘Razor and blade’ business model

Most of Ecolab’s products are sold using the ‘razor and blade’ model. For example, for its water segment which accounts for close to a fifth of its fiscal 2012 revenues, Ecolab generates a steady stream of recurring revenues from selling chemicals compatible with the water treatment equipment it installs. Another example is the institutional business segment where Ecolab’s detergents are used in dishwashers found in kitchens restaurants. Its other businesses mostly run on a similar ‘razor and blade’ model, where typically an initial sale of equipment leads to consistent sales of consumables to be used with the equipment.

In addition to recurring revenues, Ecolab also benefits from high switching costs with respect to its products. It might be an easy decision for an individual to switch to a new razor brand, but the huge capital investment involved in replacing all of Ecolab’s existing equipment with that of a competing brand is a key deterrent. Moreover, for some of the more complex equipment that Ecolab customers have to incur additional time and effort in retraining their staff for a new set of equipment.

The result of a high customer retention rate is that both investors and management do not face much difficulty in forecasting future revenues. From the investors’ perspective, they will assign higher valuations for Ecolab, given a lower risk profile and consequently lower beta. There is also a direct positive impact on the profit & loss statement, since management makes fewer mistakes in budgeting, minimizing the risk of overspending.

Company sells ‘need to have’ products

Ecolab offers hygiene, disinfection, instrument cleaning services to dentists and doctors, which are a matter of life and death for patients. It is not uncommon to read about patients suffering from complications, even dying, because of infected instruments. At the very minimum, healthcare companies cannot afford any damage to their reputation as a result of hiccups like this. Given that the quality of products matters for many of Ecolab’s customers, it just does not make sense for them to switch providers over pricing issues.

While Ecolab has about a third of its customer base made up of cyclical companies in the foodservice and hospitality industries, the direct impact of any slowdown on its sales is limited. Restaurants and hotels are likely to do less cleaning, simply because it is doing less business. Ecolab’s dishwashing and laundry services are needed at all times and not that much affected by the financial results of their clients.

Growth drivers

Ecolab completed its acquisition of Champion Technologies, a Texas based shale company in April 2013, with the aim of enhancing its upstream exposure in North America. Management expects the Global Energy segment to increase its proportion of total revenue from 17% to 26% with the inclusion of Champion Technologies. I am confident of management achieving expected cost synergies of $150 million by the end of 2015, given its previous track record of surpassing its initial cost synergies with the Nalco acquisition two years ago.

Peer comparison

Ecolab’s peers include Rollins (NYSE: ROL) and The Clorox Company (NYSE: CLX).

Rollins and Ecolab are among the largest players in the pest control industry, with Rollins being the top commercial pest control provider in the U.S. with about a fifth of the market share. Rollins’ pest control business is relatively recession resistant and it is regarded as a leader in the area of bed bugs, which are increasingly a key concern among its customers.

Despite this, I am wary of investing in a pure pest control player given the seasonality of the business. Revenues for Rollins tend to be lower in the first and last quarter of the year coinciding with lower temperatures which are less conducive for pest infestation. This is validated by Rollins’ first quarter of fiscal 2013 results which were impacted negatively by increased snowfall. Management expects improved results in subsequent quarters on the back of warmer weather and increased pest activity.

Clorox manufactures and sells household cleaners, laundry additives and infection control products. It is among the top two brands for 90% of its product portfolio and it has a cost advantage over its smaller competitors by virtue of economies of scale.

I am not considering Clorox, given that its reliance on domestic and developed markets and product categories with lackluster growth. For example, coal, which represented about 10% of Clorox’s revenues, is seeing decreased volumes with the increasing prevalence of gas grills. This is reflected in its fiscal 2014 growth rate guidance of between 2%-4%. I prefer a mix of stability and growth for my investments, which is something that Ecolab offers.

Conclusion

Ecolab enjoy high customer retention rates by virtue of its ‘razor and blade’ business model and mix of ‘need-to-have’ products. Ecolab’s financial track record is the best evidence of its high customer retention rates; given that it has been profitable and free cash flow positive for every year in the past decade. However, Ecolab is expensive at 20.4 times forward P/E and 1.6 times PEG. A forward dividend yield of 1.1% is also not sufficiently attractive. I will recommend investors to put this stock on their watchlist and wait for a better entry price.


Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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