Ecolab Continues A Switch From Defense To Offense

By Stephen D. Simpson, CFA | October 14, 2012 AAA

It's not uncommon for companies to transition to defensive plays as established market share, economic moats and slowing end-market growth discourages its new entrants. What's more, there's nothing wrong with defensive companies - they can enjoy solid margins and cash flows, and they often pay healthy (and reliable) dividends.

It's not so common, however, to see defensive companies aggressively seek to become more offensive. This transition not only creates a large amount of execution risk, it also demands capital that more conservative investors usually prefer to see directed towards dividends and buybacks. Nevertheless, Ecolab (NYSE:ECL) continues to push on with an acquisition program that has meaningfully altered its business mix and given it greater long-term growth potential.

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Buying a Champion in Energy
The first thing most investors think when hearing the name Ecolab is probably "cleaning and sanitation," and, indeed, Ecolab remains a very large player when it comes to cleaning and sanitation products, as well as services for the hospitality sector (as well as healthcare, food/beverage and other sectors).

Less appreciated has been Ecolab's sizable energy sector specialty chemicals business, a business that is the number two player in the sector behind Baker Hughes (NYSE:BHI). Now, however, the company is looking to become much larger with the $2.2 billion deal for privately-held Champion Technologies. With this deal, Ecolab will become the number one player in the segment, 50% larger than Baker Hughes and substantially larger than Schlumberger (NYSE:SLB) and Multi-Chem.

Champion is presently the number three player in this segment, with a much greater focus on upstream (95% of the business) than Ecolab's current business. Not only will this deal build on Ecolab's water treatment capabilities (increasingly important in oil/gas production), but it also adds products like hydrate inhibitors and sour corrosion inhibitors. All in all, given that these chemicals are increasingly important for improving yields, prolonging equipment life and reducing environmental damage, this looks like a solid growth investment for Ecolab.

SEE: What Makes An M&A Deal Work?

A Deal that Requires Some Management Skill
Ecolab is not exactly getting Champion for a song. The company is paying about $2.2 billion, with 75% of it in cash ($1.7 billion) and the remainder in shares (a collared deal that required about 8 million shares at the time of announcement). That works out to more than 11 times 2012 EBITDA, though Ecolab management believes that deal synergies should push that down to about 9 times EBITDA. Whether an investor looks at other energy service companies or specialty chemical companies, that's still on the high end of the valuation range.

Champion seems to have below-peer operating margins today, and that's where Ecolab management's skills come into play. This business should fit in well with Ecolab's existing operations, and Ecolab has done pretty well with the margins of its existing energy business, so management's forecasts for synergies and value accretion have some credibility. Nevertheless, with this deal levering up the business further and expanding its non-defensive exposure, those margin improvements will be critical in adding long-term value.

SEE: Analyzing Operating Margins

The Bottom Line
Ecolab remains a compelling company in many respects. Although it competes with some large players such as General Electric (NYSE:GE), Ashland (NYSE:ASH) and ISS A/S in markets like water treatment and sanitation, it enjoys solid market positions, good margins and returns, and solid (if somewhat inconsistent) free cash flow margins.

Now the company is taking on some additional risk in the pursuit of better growth. With global oil and gas production unlikely to decline any time soon, this deal for Champion should be a good compliment to its more stable operations. The company's debt level is going to be a little high after this deal, but patient dividend-motivated investors should find something to like in the company's greater long-term potential to grow dividends after this deal.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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