Recent Changes to our Economic Moats
We think the prospects for healthy, long-run returns have changed at these firms.
At Morningstar, part of our research and ratings process includes determining whether a given company possesses an economic moat. The term economic moat was coined by legendary investor Warren Buffett to describe a company's competitive advantages. Much as a moat would help protect a castle from invaders in medieval times, an economic moat helps a profitable company fend off competitors, allowing it to continue to generate outsized returns on invested capital for the long run. In fact, moats are a key part of our assessment of a firm's long-term value, as Pat Dorsey, Morningstar's director of equity research, discusses in his new book, The Little Book That Builds Wealth. For each of the companies we cover, we have assigned an economic moat rating of none, narrow, or wide, based on the firm's competitive advantages and the length of time we expect it will be able to earn excess economic profits.
A firm's economic moat can come from several different competitive advantages, including a network effect, high customer switching costs, unique intangible assets, such as patents or a strong brand, and cost advantages. A company's moat doesn't change very often. However, when industry dynamics change--for example, when increased competition threatens to erode a company's returns--we can opt to reassess the strength the firm's competitive advantages.
In this article--the first in a quarterly series--we take a look at some of the recent economic moat changes in our coverage universe, a good portion of which occurred within the media industry. We'll also take a look at some changes we made to a commodity producer and a couple of financial institutions.
|Economic Moat Rating Upgrades|
| Current |
| Previous |
|Google (GOOG)|| |
|Potash Corp. of Saskatchewan (POT)|| |
We raised Google's economic moat to wide from narrow. Morningstar equity analyst Larry Witt believes the company possesses the necessary competitive advantages to retain its dominant position in the lucrative Internet search business. Although competitors have attempted to copy Google's search technology, Google's vast resources (financial and human) have allowed it to continue to refine and improve its superior technology. By staying one step ahead of its competitors, we think Google will continue to attract more users, which should lead to more advertisers and additional profits. These new profits can be reinvested to make its search engine even better, which will lead to even more users and profits, and the virtuous cycle continues. Besides its obvious scale advantages, the company also benefits from its strong brand, in Witt's opinion. Witt believes that Google's shares are undervalued at this time.
Potash Corp. POT
We recently raised our moat rating for Potash Corp. (PCS), the world's largest fertilizer producer, to wide from narrow. Because PCS controls the bulk of the world's excess potash production capacity, the company is in a position to capture an outsized share of the incremental demand for the nutrient. As countries like China, India, and Brazil seek to boost farm production through better fertilizer use--especially higher potash application--equity analyst Ben Johnson expects that PCS will be the one supplying the bulk of the incremental tons to the market. Though it will be providing the marginal ton to the market, PCS is not the marginal cost producer. Rather, PCS is the low-cost producer, giving it a wide-moat status. Meanwhile, continued tightness in the global supply and demand balance for potash has allowed producers to capture substantially higher prices that fall straight to the producers' bottom lines, which Johnson believes will stick for some time to come. In his opinion, PCS' shares are undervalued at their current price.
|Economic Moat Rating Downgrades|
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| Previous |
|Merrill Lynch (MER)|| |
|Morgan Stanley (MS)|| |
|Idearc (IAR)|| |
|R.H. Donnelley (RHD)|| |
|Belo (BLC)|| |
|Gray Television (GTN)|| |
|Hearst-Argyle Television (HTV)|| |
|LIN TV (TVL)|| |
We recently decreased the moats of Merrill Lynch (MER) and Morgan Stanley (MS) from wide to narrow. Both companies made large missteps last year in the mortgage market, showing that they didn't have as strong a handle on the risks they were taking, as equity analyst Ryan Lentell once believed. Lentell cautions that the uncertainty around these investment banks remains very high today. That said, he still thinks these are moat-worthy businesses that will produce returns above their cost of capital over the course of a cycle. Merrill and Morgan's large wealth-management groups (Merrill has more than 16,000 financial advisors, and Morgan has more than 8,000) support the firms' narrow moats. These global wealth-management groups provide each firm with a strong distribution network and steady revenue stream. Despite the moat-rating downgrade, Lentell believes these companies are undervalued today.
We lowered our economic moat ratings for Idearc (IAR) and R.H. Donnelley (RHD), two directories publishers that we cover, to none from narrow. Publishers of directories have historically enjoyed stable and visible revenue from a stable customer base, resulting in very impressive profitability. However, we think the industry is in the early stages of a long transition to new media, which doesn't bode well for Idearc and RHD. We see potential for decreased pricing power for their high-profit print products (which still generate the vast majority of their revenues) and meaningful competition for their digital services, which, combined, should result in lower profitability. This is especially problematic, given each company's heavy debt load; in fact, RHD decided not to initiate a planned dividend in order to help service its debt, and Idearc recently cut its dividend for the same reason. We think Idearc and RHD are both currently overvalued.
We also lowered the economic moats for the four pure-play television broadcasters that Morningstar covers-- Belo (BLC), Gray Television (GTN), Hearst-Argyle Television (HTV) and LIN TV (TVL). Local television broadcasters still benefit from their ability to aggregate mass audiences at the local level for marketers, and we expect strong political advertising in 2008 and the growth of high-margin retransmission consent fees over the next few years. However, new forms of media continue to steal consumers' eyes and advertisers' dollars. We think that national advertising (which makes up around a third of their total broadcast advertising revenues, excluding political) is at risk, in particular. Many broadcasters are focused on paying down debt in the near term, but we're concerned about the potential for poor capital-allocation decisions in the future. Because of limited organic growth opportunities in the mature broadcasting industry, they could overpay for acquisitions to spur growth. We don't see any value in their shares at their current prices.
James Walden does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.