ECL is the dominant provider of cleaning, sanitizing, and water treatment services to businesses. Its unique capabilities and scale afford it numerous competitive advantages, and its razor / razor-blade business model produces consistent returns on tangible capital in the range of 20%. ECL has traditionally grown free cash flow at a double-digit annual rate, with minimal cyclicality. It currently possesses only 11% of its highly fragmented market, providing a long runway for further growth.

On December 1^st, ECL closed its transformative acquisition of Nalco, which is the world’s leading provider of water treatment services. Although Nalco has similar business characteristics, it is slightly more cyclical, which has been a concern for shareholders who were attracted to ECL’s predictability. This may explain why the stock is trading below its traditional multiple of 20x+ forward free cash flow (defined as net income plus intangibles amortization).

ECL trades for 15x 2012 free cash flow guidance of $3.60-$3.70 per share. Currently underway are two separate cost cutting initiatives, which together should increase operating income by approximately 15% within 3 years. In addition, the $1 billion share repurchase planned for 2012 would reduce the share count by 7%-8% at current prices. Finally, ECL intends to reduce the debt / EBITDA ratio from 3x to the traditional 1x, implying about $4 billion of paydown.

Revenue                     $11 billion (annualized)
Stock price                $54.35
Diluted shares           309 million
Market cap                $13 billion
Debt                            $6.3 billion
EV                               $19.4 billion

Business description
Pre-merger ECL provides products and services for cleaning, sanitizing, food safety, and infection prevention, to businesses worldwide (this discussion will exclude Nalco, which is covered later). For example, the company sells detergents use by most major restaurant and hotel chains to clean dishes and laundry. Customers typically use ECL’s dispensing equipment (the razors, which are leased or provided free), and pay for the chemicals (the razorblades) under 3 to 5 year contracts.

Although 90% of ECL’s revenue derives from consumable chemicals, the principal element of its value proposition is comprehensive service provided by a force of nearly 15,000 associates. ECL’s sales-and-service associates work closely with customers to achieve consistent results at the lowest cost. They provide an initial comprehensive assessment and employee training, and then visit on a monthly basis to monitor and consult on operations. They are also available 24/7/365 to troubleshoot problems, such as equipment breakdowns. ECL’s products typically cost 20% more than the alternatives, but most customers experience net cost savings related to labor, energy, or other efficiencies. 

The business is attractive for several reasons:

• ECL possesses economies of scale and scope. The company’s 11% share of its estimated $57 billion global market is approximately twice that of its nearest competitor, Diversey. ECL is dominant in the US, and enjoys leading oligopolistic positions with Diversey internationally. The rest of the market is highly fragmented, consisting of local or regional firms with limited offerings. ECL has the broadest product line and can service clients in the most locations. This is especially important to multinational customers (such as Marriott, Nestle, Coca-Cola, etc.), which desire standardized solutions across their operations. Such global companies comprise 60% of ECL’s revenue, and are becoming increasingly important as they consolidate their industries.
• ECL offers the best technologies. While cleaning and sanitizing products may not seem to lend themselves to innovation, ECL has a long history of producing new products that are valuable to customers and accretive to its margins. Over 35% of revenues typically come from products introduced within the last 5 years. For example, a recent innovation is a laundry detergent that reduces by 40% the heat necessary for ECL’s hospitality customers to clean linens, yielding energy cost savings and longer linen life. ECL’s technology advantage is perpetuated by its economies of scale in R&D. The vast majority of competitors have minimal R&D budgets and offer commodity products, whereas ECL spends nearly $90 million per year (one-third more than Diversey).
• ECL is the de facto industry standard for critical services. ECL plays a critical role for its customers; errors in cleaning and sanitizing can lead to health hazards, compliance violations, operational disruptions, or brand degradation. At the same time, ECL’s capabilities are unmatched, and its reputation for service and reliability is unrivaled—making it the logical choice as a critical vendor.
• ECL represents a small cost to customers. The incentive for customers to choose the most trusted vendor is compounded by the fact that cleaning and sanitizing products average only 0.5% of their revenue.
• There are high switching costs. ECL is typically embedded in its customers’ operations. Employees are trained on ECL equipment and protocols, and come to rely on ECL’s sales-and-service associates to keep things running smoothly. Switching to an alternative vendor would be disruptive, especially for multinational companies that use ECL across the world.
• ECL’s recurring revenue model is highly predictable. As mentioned before, 90% of revenue is derived from sales of consumable products, which are used for necessary functions. Customer retention rates average 90% annually, and many customer relationships have existed for decades. All of these factors contribute to a high degree of visibility and minimal cyclicality.

In combination, the above factors have permitted ECL to earn solid operating margins and attractive returns on tangible capital for a long time. The following table shows these metrics since 2002:

                        Operating margin     ROTC

2002               12%                            21%
2003               12%                            18%                           
2004               12%                            17%
2005               12%                            18%
2006               13%                            20%
2007               12%                            21%
2008               12%                            22%
2009               12%                            21%
2010               13%                            21%

The business has also exhibited steady growth and minimal cyclicality, as is shown below (free cash flow is defined as net operating profit after taxes, excluding non-recurring items, plus amortization of intangible assets):

                        Revenue                     Organic revenue       FCF per share

2002*              47%                            4%                              40%   
2003               11%                            10%                            6%
2004               11%                            9%                              11%
2005               8%                              8%                              11%
2006               8%                              7%                              16%
2007               12%                            8%                              16%
2008               12%                            6%                              10%
2009               -4%                             0%                              5%
2010               3%                              2%                              11%
2011 YTD      10%                            4%                              11%

* Reflects consolidation of the remaining 50% of ECL’s European joint venture with Henkel, which was acquired on November 30, 2001.

EMEA restructuring
Margin expansion in the US segment has been offset by contraction in the International segment (which comprises about 50% of revenue). International’s contraction can be traced to ongoing restructuring efforts in EMEA, which comprises approximately 30% of total company revenue and has only a 4% pre-corporate operating margin. Below are reported pre-corporate operating margins by geographical segment for the past 4 years:

                        US                   International
2007               15.5%             10.0%
2008               15.4%             9.1%
2009               18.0%             8.0%
2010               18.5%             8.4%
2011 YTD      18.3%             8.9%

The EMEA business was built from several acquisitions during the 1990s, culminating with ECL’s 2001 acquisition of Henkel’s interest in their joint venture. The disparate units were run separately until the mid-2000s, when the company belatedly acknowledged the inefficiencies of doing so. ECL then embarked on a process of consolidating its EMEA operations, which first necessitated bringing each country onto a common IT platform. A multi-year SAP implementation was completed in 2010, which should enable ECL aggressively to take out costs, primarily in the supply chain, but also through G&A reductions. These efforts, combined with further top-line growth, are expected to yield 1000 bps of operating margin expansion (from 4%, on a pre-corporate basis, to 14%) in the EMEA business, with half of the improvement materializing in the next 3 years.

Although 1000 bps is a striking figure as a goal for margin expansion, the 14% margin objective is still well below ECL’s level in the US (~18%). Another point of reference is Diversey’s operating margin in its European business, which is 10%. If ECL’s EMEA margins were to reach 10% (as is expected by 2014), this would imply approximately $115 million of incremental operating income.

Nalco acquisition
Last December, ECL completed its transformative acquisition of Nalco for $38.80 per share in cash and stock—a total value of $8 billion, including $2.7 billion of assumed debt. Nalco represents 40% of the combined company’s revenue and operating income.

The acquisition multiple of 22x 2011 EPS is somewhat deceiving, because of interest expense benefits and significant intangibles amortization. ECL is refinancing Nalco’s debt, bringing the associated interest costs to 3.9% from 7.2%. Adjusting for this factor and adding back amortization of intangibles, ECL paid 16x 2011 free cash flow. This appears to be a reasonable price considering Nalco’s business quality and prospects, as well as expected cost synergies equal to 25% of Nalco’s operating income (there are also potential revenue synergies, discussed below).

The transaction is $0.60-$0.70 accretive to 2012 free cash flow, guidance for which is $3.60-$3.70 (before the planned $1 billion share repurchase). Pro-forma ECL has $6 billion of net debt, which implies a debt / EBITDA ratio of 3x (above the conservative traditional leverage ratio of 1x, but manageable).

Nalco is the world’s leading provider of chemical-based water treatment services, which means that it helps businesses to decrease water usage, minimize downtime of facilities, extend asset lives, and enhance process efficiency. Its main customer segments are industrial, energy (oil and gas), and paper. The business model is directly analogous to ECL’s: Nalco derives the vast majority of its revenue from consumable chemicals, but also provides comprehensive service and support through a force of 7,500 highly trained engineers and service technicians. Like ECL, Nalco is the industry leader, with dominant market share (except in its Paper segment, which comprises only 15% of pre-corporate operating income) and with only one global competitor (GE Water). Nalco has unmatched technology, the most highly skilled sales and service force, and a reputation as the de facto industry standard. Its services represent a small cost to customers, provide significant net cost savings, are critical to operations, and have high switching costs. Retention rates are over 90% annually, and 19 of the top 20 relationships are over a decade old.

Nalco’s leading position is particularly desirable because demand for its services is a function of a long-term mega-trend: water scarcity. The UN estimates that 2.6 billion people (over 1/3^rd of the world’s population) lack access to enough sanitary water for normal living conditions, and that 80% of all illness and death in the developing world is traced to the consumption of contaminated water. As economies modernize, industrial usage of water grows from 10% of total consumption to 60%. The growing importance of enhanced oil recovery is driving increasing water intensity in energy production. Numerous global companies—such as Coca-Cola, ConAgra Foods, ChemChina, etc.—have announced specific long-term goals for water use efficiency or reduction. The ECL acquisition provides Nalco access to food & beverage and hospitality customers, on which Nalco traditionally did not focus.

As mentioned before, certain characteristics of Nalco were turnoffs to ECL shareholders, who traditionally have been attracted to ECL’s transparency and predictability. Indeed, Nalco’s history is not one of smooth and steady progress. Nalco was an independent, publicly traded company until it was acquired by Suez Lyonnaise des Eaux in 1999, which combined the company with its own water operations. Suez Lyonnaise was overleveraged and starved Nalco of personnel and capital, eventually selling it to private equity in 2003. Only one year later, Nalco IPOed again with $3.2 billion of debt (debt / EBITDA of 7x).

In the ensuing years, Nalco enjoyed modest growth and deleveraged to less than 5x debt / EBITDA by 2008. That year, Nalco wrote down the goodwill associated with its Paper business (which, as mentioned before, is its weakest) to zero, resulting in a $544 million impairment charge. Also that year, Erik Fyrwald joined as CEO. Fyrwald refocused the company on growth, reducing the number of customer sites from 70,000 to 50,000 by shedding the smallest accounts, and investing in Nalco’s emerging markets sales force and infrastructure.

In 2009, Nalco explicitly doubled its target organic growth rate to 6-8% per year, just as its business was impacted by the recession. Reported revenues dropped 11%, marking the first year in over a decade in which revenues declined. However, excluding foreign currency translation rates and a small divestiture, organic revenue was down 7%, and organic gross profit declined by only 2%, due to cost management. Although Nalco is more cyclical than ECL (which posted flat organic revenue in 2009), as businesses go, Nalco has proven to be stable. Like ECL, Nalco is a minimally cyclical growth business that earns strong returns on tangible capital, has low-teens margins, and generates free cash flow.

Recent results suggest that Nalco’s growth plan is hitting its stride. Organic revenue rebounded by 7% in 2010 and for the first nine months of 2011, it is up another 12% (excluding a one-time sale last year related to the Deepwater Horizon). Over the past two years, the company added approximately 1,350 people to its sales force (an addition of roughly 20%). Because there is a 12-to-18-month lag before such hires become productive, the benefits of this investment are just beginning to materialize. Nalco’s operating income is expected to grow at a mid-teens rate for the next several years, ignoring potential merger synergies.

The combined company
The combined company appears to be superior to ECL standalone, for at least two reasons. First, the customer base is more diversified. The vast majority of Nalco’s revenue is derived from industrial and energy firms, whereas ECL’s customers are predominantly consumer businesses. As a result of the transaction, ECL’s two largest exposures—foodservice and food & beverage—have shrunk from 35% and 25% of revenues to 20% and 17%, respectively.

Second, there is an opportunity for Nalco to penetrate ECL’s customer base, primarily in food & beverage and institutional. Historically, Nalco did not focus on these categories, in which accounts are relatively small, and together they currently comprise only 10% of Nalco’s revenue. The company’s 5-year goal is a relatively modest $500 million of annual revenue synergies (11% and 5% of Nalco and total company revenue, respectively). Management believes there is a significantly greater long-term opportunity.

• The company will buy back $1 billion of stock in 2012, equal to 7%-8% of the company at current prices.
• $150 million in cost synergies are expected to be realized over 3 years. Together with the restructuring of EMEA, this represents an opportunity to increase operating income by about 15% by 2014.
• ECL intends to bring leverage down to the traditional debt / EBITDA ratio of 1x, from the current 3x.
• ECL’s long-term EPS growth objective is 15%, and the company has made optimistic comments regarding the possibility of exceeding that objective over the next few years. While projections should be taken with a grain of salt, ECL has a long history of executing on its ambitious goals.