Ecolab: Clean Machine - [Business Breakdowns, EP.214]

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1:41This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This is Matt Russell and today we are breaking down Ego Lab. As of this recording, EgoLab has a $66 billion market cap, so they are a giant in what they do. They protect over 36 % of the world's packaged food supply and over 44 % of the global milk supply, just to give you some sense of their business. My guest is Todd Wedding, founder of KNA Capital Management, and someone who has a knack for finding these interesting businesses. is we get into the very on -brand origin story for E .C .O.

2:21Lab many decades ago how the business kept that core focus throughout its history and how it became one of two vendors that any U .S. McDonald's must work with, the other being Coca -Cola. There's a ton of interesting threads in this one, but the opportunity in water is what really grabbed my attention. It's one of these thesis you've heard for many years and I had never come across a business with the exposure that EcoLab has. So an interesting one to do more research on. Now please enjoy this breakdown on EcoLab. All right Todd, I am excited to have you here to break down EcoLab. You have a knack for finding very interesting that operate in unique corners of the world and the economy.

3:08EcoLab definitely fits that bill. So just to kick us off, the introduction to ECO Lab, who they are and what they do, and then we could take the conversation from there. Thanks, Matt. The best place to start with ECO Lab is how it was founded, because that is the cultural DNA that exists with the company today. So in the early 20s, a salesman named MJ Osborne was traveling around and noticed that hotels were closing rooms for multiple days at a time because they had to be cleaned and they were using water. And so the carpets would get wet, they couldn't turn the rooms and they were just kind of being wasted.

3:47And so Osborne figured out that with some chemicals and he called it absorbent, it's a great name. He could help the hotels turn the rooms faster by making the cleaning process shorter, that saved money for the hotels and it made money for his business. And so he started growing this. And so the name EcoLab comes from economics laboratory. You might think it's ego in terms of ecology based on where it is today, and that would make a lot of sense But it actually takes its root in economics the borritori So saving money and doing it in a scientific way and that is what ego lab continues to do today So it's had many different phases many acquisitions many the vestitures, but when it comes down to it That is still what ego lab does today.

4:31It's very interesting. I did not appreciate the naming origin I love any type of initial sales process that revolves around. Here's a way where what we sell can make you a lot of money and it's very obvious and upfront. Certainly the case here, fast forwarding to today, it seems like they have their hands in many different worlds beyond just hotel rooms. So is there a way to take a snapshot of where they operate today in terms of segments of the economy and what they do? So about 50 % of their revenue comes from their industrial business, which they're renaming the water business. That came from the NALCO acquisition, which we'll talk about.

5:14About 35 % comes from their legacy institutional business, which is cleaning hygiene solutions for quick -serve restaurants, hospitals, and so on and so forth. Then you have about 7 % in life sciences, health care. and then remaining 7 % or so in the pest elimination business, which is actually a really great business. It's a B2B business, which they cross sell to their existing customers. And that's a great, steady margin business, 20 % operating margins. So we can talk about that too. So they've got a lot of things going on at ECOLEAD, but again, it all comes back to what MJ Osborne wanted to do from the start.

5:52Does it all revolve around chemicals or is it broader in terms of cleaning? Like if there were ways to categorize the actual focus of the business, would you use either of those two categories? Chemicals are really at the foundation of E .G .O. Lab. That's going back to Osborne. That's what he started with figuring out how to use chemicals to solve a customer's problem. Over the years, the company has added new chemical applications. So it made a really big acquisition in the 90s called K chemical. and they were the chemical cleaning providers to the quick serve fast food restaurants. And that was another really transformational acquisition for them.

6:31There, they got the McDonald's business. And what's an interesting fact about the McDonald's business in the US, McDonald's has two vendors that they have to work with. One is Coca -Cola, the other is EcoLab. That's how powerful the EcoLab brand is in the quick serve restaurant space in the US. Now, the McDonald's franchise is outside of the U .S. Eco -Labs are on the preferred list, but they don't have to use Eco -Labs. But it still tells you just how strong Eco -Labs brand is. And so it goes back to solving problems with chemicals. And one of the major things that they've done over the past couple of years is go from liquid chemical sales to solid chemical sales.

7:09And this all goes back to saving customers' money. And it also talks about their really big push and sustainability. So if you're a McDonald's restaurant, it It makes far less sense for you to have buckets of chemicals shipped you and stored in closets because you've got high employee turnover. They can mix chemicals the wrong way. They can cause problems. It takes up a lot of space. So what EcoLab has done is they sell it in solid form. You just drop a concentrated dose into your spray can and you can use it that way. They also have hardware installed in some cases where they bring the chemicals in the solid form to the restaurant and the restaurant provides the water.

7:51They mix together and they can get the dosage that way. And so that way you're not shipping water on trucks to get to the restaurants. You have the assured dose that you want. There's far less safety issues involved. So that's just again going back to the solution that EcoLive has. And they've always had this idea of what's called circle the customer. And that's one of their core principles is get all the way around the customer, try to figure out what their problems are, how can we solve them? Let's take it back to the R &D lab, let's figure out a solution, and let's distribute it to our whole customer base.

8:23Just thinking about how that can impact so many different pieces of the business and weight and storage makes a lot of sense. In terms of size of the market, is there any way to capture how big it is and how big EcoLab is in terms of fitting in? I think the McDonald's point makes it clear in terms of them being a leader, if not de -leader, but how would you go about framing it just from an industry perspective? The opportunity is pretty big. So right now they have about $16 billion in revenue and they see an opportunity to cross sell another $55 billion into their existing customer base. And then an additional $81 billion into the untapped market where they have no presence.

9:05One of the issues that I've always had with ECOLAB in terms of thinking about their TAM is that they work really well with large multinational companies, or regional or national companies, but their value proposition isn't quite as strong with small Bob and Pop restaurants. So if you're running an independent restaurant here in town, EcoLeb comes in with a 20 % premium price, which is generally what they have. And it's like, hey, we can solve problems for you and save you money, but when you're trying to make ends meet as an independent restaurant, you're just trying to hit margins and you're trying to figure out, okay, how could I do this as cheaply as possible to stay in compliance?

9:42And so they don't sell that well to independent mom and pop places. Now, they might be able to sell you on their dish washing. And that's sort of how they get their foot in the door. What they do is they lease dishwashers to the owner and then sell the chemical. That's how they get entry into a lot of these places. But it's really more challenging for them to make a good pitch to a smaller mom and pop shops. The opportunity with the Nalco acquisitions is probably good opportunity to step back and talk about the now co acquisition. So in 2011, they made a really transformative acquisition. The backstory to now go was they were working with mostly heavy industrial.

10:21So think about water solutions, chemical plants, pulp and paper was another big business energy. And so trying to help them figure out their water usage. And that asset had been passed around quite a bit. They actually had a very similar origin story as E .C .O. Lab and they grew up in Naperville, Illinois, founded around the same time. Later on, E .C .O. Lab would say these guys were our long lost brothers and we brought them back into the fold. The backstory there is they were passed around. They were once owned by Alcola. They were owned by Suez at one point who is a current competitor. Suez got into financial trouble.

11:00They sold it to a private equity consortium, which LB Ode, Nalco in 2003, and saddled them with a ton of debt. And so by 2010, the company had a single B credit rating, was really struggling. At the same time, you had EcoLab, who was trying to figure out where is the puck heading next. And it was a really genius move in hindsight. At the time, I was a little concerned about why they did this because they had this really nice razor and blade business model with low volatility. I think the beta used to be 0 .6 or something. A very steady business recession resistant. And they went out and made this large investment.

11:38It's about 30 % or so of their market value in NALCO. What their vision was by Christoff Beck, who was then executive vice president at EgoLab and Doug Baker, the CEO at the time, was that water is the future. Is that water purification essentially like cleaning of the water that would otherwise come out of the taps with some type of mineral inequality. That's part of it. So they don't work in municipal water at all. So these are mostly situations like mining and downstream oil and gas and paper and pulp. So you think about paper and pulp. I used to cover the paper and pulp industry and I was at Morningstar and you see these huge vats where they're bringing in this pulp, they're processing it to be recycled and there's huge, huge amounts of water.

12:25And when you think about the amount of water that's being processed, both on the industrial side, as well as the food and beverage processing, and increasingly data centers and semiconductor creation, one new fab, semiconductor fab uses the equivalent drinking needs of 17 million people. So it's huge, huge amounts of water to produce the semiconductors and data centers talking about cooling, 40%, 50 % of the water evaporates. We only have a limited amount of fresh water, and not all of it meets the standards for every need, depending on where you live in the world. The water chemistry could be different.

13:03The genius move there was noticing that there is this huge tailwind behind water in the coming years that the cost of fresh water has been rising, and E .Colab can use its R &D, its expertise to improve that for everyone. So reduce water needs to recycle water needs and to conserve water. Making sure that we're not wasting the fresh water that we have because the tailwinds behind fresh water demand are only increasing with population growth, increased food needs, and so on and so forth. So EgoLab has come up with a lot of solutions to address those issues. In many ways, it's obvious how that blends into what they were already doing in terms of chemical usage that might speed up that process, make it more efficient.

13:49On the other hand, it seems like the customer base would be very different. Just from a synergistic standpoint, especially in hindsight now, given this was done close to 15 years ago, what was the outcome of that in terms of their ability to, obviously, it sounds like, improve the R &D process and use some of their expertise there. but more broadly, how did these two businesses end up fitting together? The entree, so to say, for ECO Lab, was the food and beverage business. So Nalco was working a lot with food and beverage processing plants. So I think about breweries, food processing. So they touch on 36 % of the world's processed food.

14:29So they are involved at some step and 36 % of the world's processed food. They have a huge opportunity. And so they had a lot of existing relationships in the food and beverage industry through their hygiene and sanitation. And so now they could go into an existing customer and cross sell narco water. Hey, we can help you with treating your boiler to make sure it doesn't have any foul ones in it, that it doesn't destroy your boiler and you're using more energy, using more water to hit your solution. So that is the real entree into that. And then once they got into that, they could begin to use some of EcoLabs expertise to apply to the other industries.

15:06And what now go really brought to the table was this product called 3D Tracer, which is employed in industrial water processes. And it reads what's going on in the water system at all times, and so it shoots that information back. And then you can imagine, EcoLab taking that information and saying, hey, we can come up with chemistry to help you figure out how to reduce the balance in your system, improve your water quality, reduce water usage, reduce energy uses, and so on. Very interesting. It brings up a point on all sides of the business. Do you have a sense of when they're working with a customer, whether it's McDonald's, a brewery, a mining operation?

15:46Who is the buyer of Eco Labs, various product segments offerings? It's not obvious that it would be the chief revenue officer or the CFO, but do you have a sense of who is in charge of what Eco Lab does for various businesses? It varies by the business for sure, but it's really coming down to the person who's responsible for the expenses and the long -term project revenue or the return on investment for the project because that's what this is. Actually, Ekelev has a new formula that's based on the ROI that it provides to the customer. That's one thing that's moving towards is more of a value -based pricing model, where it can now go to the customer and say, look, we've saved you this much money, we've saved you this much on energy, we've saved you this much on water.

16:35Here's our pricing. Instead of just raising it one, two percent a year as it has historically done, it can now go and say here's the value opportunity. So decision maker varies between food and beverage and mining. It really comes down to the person in charge of making that investment in E .Cole. Because that's really what it is. That it's an investment. That makes sense. It's a good opportunity to bring in a bit more on the revenue discussion. and you tapped into it a little bit there just in terms of the pricing mechanisms. But how does the company operate? Is it contracts? Is it just volume -based in terms of what they're selling?

17:08Sure, there's gonna be some variance depending on what it actually is. But do you have any snapshot of what that looks like? It does vary, but it's usually about three to five year contracts. And if there's a chemistry component to it, there's an estimate of how much chemistry is being used and then that gets deducted from the usage over time. So that's typically how EGLEB structures these and from an economic most perspective even though they're three to five year contracts the switching costs are so high. In fact, with the data centers, they're installing a lot of this stuff when they're building the system or the data center and the fabrication plants.

17:43It's already being built into the system and there's zero appetite for downtime once things get going. And so they can really name their price. They try not to, right? they'd want to make sure they stay with the customer long -term. But when you're a global company, when you're a multinational company, whether it's food and beverage production, whether it's data centers, whether it's fabrication plans, you want to work with a company like E .colab because they have a global reach. I mean, there's 48 ,000 employees, 28 ,000 of them are sales and service people. The 170 countries, they're all over the world.

18:14If you work with E .colab in the United States, you know you can work with them in other parts of the world. They just have their hands everywhere in the world in terms of their ability to address customer needs. Yeah, I'm sure that extends both for international expansion and thinking through that or even just new problems that arise and knowing you might be able to find a solution in terms of what ECO Lab can offer. On the sales process and one of the things you brought up was the dishwasher example with some restaurants, mom and pops, or even it sounds like having some type of software that can monitor inside a brewery, what's happening.

18:52It sounds like there's some connectivity to hardware in these places. Is that a common thing for all of their customers that they have some equipment that is obviously going to make the switching cost really challenging? But can you just talk to that strategy a little bit? Yes, that's increasingly been the case and that's another fortunate byproduct of having these solid chemicals instead of selling the liquid chemicals into the food and beverage space and the restaurant space. A lot of times they come in, they'll install the hardware into the McDonald's and if there's a new restaurant, like a new Shake Shack being built, they'll have it installed already.

19:29So the idea of switching it is so hard. In addition to the hardware, they also have these deep personal relationships with their E .G. lab sales people. They're really good field service folks are the ones who build these relationships with people in their region. So once you've established that relationship, Betty or Joe, whoever your sales person is, becomes part of your business and bit part of your process. And so to switch out, Eagle Lab means Joe and Betty are coming by anymore. They're friends of mine. And so it's a really strong sales culture. That is, if I had to define their culture, some companies are engineering focused, and Alco certainly was more engineering focused, EcoLabs very much a sales -oriented business.

20:11In terms of the swings that you can see in revenue, you gave me some sense with the beta back when post -financial crisis, which suggests that there was some strength in the operating performance through that period of time. But how sensitive are they to just general economic factors? Does usage end up resulting in major swings to the revenue base? Or is there anything else that results in revenue volatility in periods of macro weakness? So we haven't seen a real strong recession with Nalco under ECO Labs wing. So they brought on Nalco in 2011. So after the recession from the financial crisis, COVID, there is a big shock obviously to hospitality and to food of the restaurants.

20:58So there is a strong about 25 % organic volume decline during that period on a year of your basis, but that's to be expected. And it recovered very quickly. So I don't like hope not to see another situation like that. But overall, the organic volume in pricing growth has been very steady, especially for the institutional business. When I look back at the Nalco business, there was a bit of a shock in 2009, but the adjustity bit the margin, they had a big impairment that year, so it wasn't Apple's apples, but their profitability didn't decline as much as I would have expected it to. Even though the cyclicality of Eko Lab has increased with the acquisition of Nalco, I do think they are recession resistant.

21:37They did spin off. They made another acquisition two years later in 2013 of company called Champion, which was an oil and gas focused business did not work as well as they expected and they eventually spun it off into the company that's currently called Champion X. They took some of the upstream that now go ahead and combined it with this business and spun it back off. There was not an impairment related to that even though I thought it was kind of a bad decision at the time because that's when everyone was kind of rushing into energy investments with hindsight they handled it about as well as they possibly could.

22:10Yeah, speaking of cycles. Exactly. That's one sector that certainly has them. And you mentioned a little bit about the steady state on pricing looking somewhere between 1 % and 2%. Do they have a general model or framework for thinking about what organic growth can be year to year, using that volume plus price? So they're targeting five to 7 % revenue growth every year, but at least their long -term average is what they're looking for. And I think they can take about two to three percent price every year. They used to take one to two and I think coming out of COVID in this recovery, they started to notice within inflationary pressures, we can take a little bit more.

22:48Perhaps we were fighting a little bit too much consumer surplus to our customers and kind of recovering some of that. They're trying to get back to their operating margins at 20 % by 20%, 27. They're well on their way. Most of that's going to come through gross margin through pricing, a little bit on S, G, and A, but most of us going to come through pricing. And where is it today out of curiosity versus that 20 % target? They're not too far off now. They're approaching that number. I think at the last time I checked, they were about 18 % for their operating margins. So they're getting much closer to that.

23:21And I'm expecting them to get there when they expect to in 2027. And is that a reasonable mature state 20 % operating margins is there much runway post that? How would you think about it on a steady state basis? I think that's probably a good steady state to start. Some of that could change if we have a real push into the water business. If the water business does pick up the way I expected to, you could see a little bit more operating leverage, but there's a lot of variable cost in this business. So it's not gonna have a ton of operating leverage related to it. And then just thinking about how much of this is converting into free cash flow, So can you talk a little bit about that in terms of earnings conversion, any unique free cash flow dynamics with the business not immediately come to mind, and then we can talk about capital allocation?

24:11They talk about 90 to 100 % free cash flow conversion. So it's a very free cash flow generative business and kind of dovetailing into capital allocation. They've raised their dividend for 33 consecutive years. It's a very strong cash flow business and hasn't been an issue even in recessionary periods of pre -cashable has continued to be generated. On the M &A front, there's obviously some history of large strategic acquisitions. Is that always a piece of the DNA? Are they always out there looking, even if it's not quite that size, for attractive bolt ons or anything else along those lines? So M &A is certainly part of their DNA.

24:48Their capital allocation from a Sherry purchase standpoint, they're not really opportunistic. They're just buying roughly what they're paying out in dividends every year. They're buying back and so it's about 50 -50 split. M &A is always on their mindset. They'll tuck in things once in a while. I do not expect them to do anything the size of NALCO. They have been very strong in saying that culture comes first. They don't see any large companies with the culture that NALCO had that they thought they had a nice relationship with. That's available. So I would expect them to do more bolt -ons than anything else.

25:20One of the things I do like about them as well is they are willing to take a divestiture. A lot of companies will try to make something that's not working, kind of hold on to it too long. Any investor knows how that feels, holding on to something, just hoping it comes back. But they are quick and open to divesting projects that just aren't working. And I think that's a really good sign of good capital allocation. I agree. It's one of the things that I often look for of, if M &A is in your DNA, do you also look for opportunistic divestitures? Because I think that can just show a signal to the market that you're thoughtful on both sides of the equation.