"Change is inevitable. Change is constant.”
So said British statesman and novelist Benjamin Disraeli. He had a point. Kids grow up. Summer eventually gives way to fall. And if left long enough in your refrigerator, last night’s dinner will change, too.
The same can be said for companies--they change. Cash-burning startups, if managed properly, generate profits at some point. Some build significant competitive advantages. More-mature and already profitable companies, meanwhile, face new competitors. Some adapt and innovate; others stagnate and cede market share.
Related, Morningstar’s Economic Moat Rating for a given company--whether that rating is none, narrow, or wide--can change, too, based on whether a company’s competitive advantages (or lack thereof) shift.
In July, we adjusted the economic moat ratings on four companies--two received upgrades while two were downgraded. Here’s what our analysts had to say about each.
Upgrade: Splunk (SPLK)
Economic Moat Rating increased to Narrow from None
“We are raising our fair value estimate for Splunk to US$154 per share from US$126 while changing our moat rating to narrow from none and maintaining our positive trend rating. We are upgrading our moat rating to reflect our increased confidence in Splunk’s ability to attain sustainable profitability.
In a world where machine data is growing at an exponential rate, Splunk’s platform is empowering companies to generate meaningful, real-time insights from the data in order to maintain critical operations related to security and IT infrastructure. A key advantage of Splunk’s platform is that it can easily index massive amounts of unstructured, machine data using a proprietary "schema on the fly" process. This indexing process quickly identifies fields like user IDs, time stamps, device sources, and error codes, and offers a user-friendly querying tool to generate real-time, actionable insights from the data. Machine data is expected to increase over 40-fold from 2009 to 2020, and the amount of data that Splunk’s platform allows customers to process in real time sets it apart, with its largest customer collecting over 7 petabytes of data per day. We believe that this unique schema-on-the-fly indexing process has allowed Splunk to carve out a moat and provides it the opportunity to increase by revenue double digits for the next decade.
Given the company's technology platform, which can be used to better manage operations at the busiest airports in the world as well as Subway restaurants, we believe no competitor can address the same breadth of use cases as Splunk. We believe that improving customer metrics indicate increasing customer reliance on Splunk due to its flexible deployment options and the growing importance of machine data. Over 80% of new license bookings come from existing customers while the average license order size more than doubled from 2014 to 2018. Splunk is seeing similarly strong trends in large order growth and rising maintenance renewal rates.”
--John Barrett, analyst
Upgrade: VeriSign (VRSN)
Economic Moat Rating increased to Wide from Narrow
“We took a fresh look at VeriSign and are raising our fair value estimate to US$136 per share from US$120 while changing our moat rating to wide from narrow and maintaining our stable trend rating. We are upgrading our moat rating to reflect increased confidence in VeriSign’s ability to secure renewals of its prized dot-com agreement with ICANN. We believe that VeriSign’s strong operating history (over 21 years of continuous availability of the dot-net and dot-com domain name systems) makes it highly likely that it will continue to see its contracts renewed, providing room for additional revenue growth while maintaining exceptional operating margins. But with the stock trading near US$215 (or nearly 40 times our 2019 adjusted earnings estimate), we think that shares are overvalued at these levels.
In the second quarter, VeriSign’s revenue and earnings continue to grind higher, in line with consensus on revenue and slightly ahead of consensus non-GAAP EPS expectations. The only sign of weakness was a slight drop in renewal rate, due to lower first-time registration renewals in emerging markets like China. Per usual, there were limited material developments on the call. VeriSign continues to negotiate with ICANN to get Amendment 35 incorporated into the cooperative agreement but did not provide an update on how negotiations were progressing. There was no update on the arbitration involving the dot-web auction.
For the quarter, the company reported revenue of US$306.3 million, flat sequentially and up 1% year over year. Total domain registrations grew by 1.34 million for the quarter with dot-com adding 1.5 million domains and dot-net shrinking by 0.2 million. Non-GAAP operating margin was the highest it's ever been at 70.1% for the quarter. For the full year, management now expects operating margins for 2019 to be 68%-69%, an increase of 50 basis points on both ends of the range, indicating operating expenses should increase in the back half of the year.”
--John Barrett, analyst
Downgrade: Fiserv (FISV)
Economic Moat Rating lowered to Narrow from Wide
“We view the merger between Fiserv and First Data as dilutive to Fiserv’s existing wide moat, and we are downgrading our moat rating from wide to narrow. The resultant company will still derive its moat from switching costs and a cost advantage in merchant acquiring. Fiserv brings two businesses to the table: core processing, which is the software that runs the extremely important general ledger function of a bank, and payment processing, which enables banks to process electronic payments. It is important to note that Fiserv’s moat in payments is derived from the company’s position as core provider since these two servicers are usually bundled and cross-sold together. A financial institution’s general ledger most often referred to as the bank’s core is what allows financial institutions to maintain accurate balance information and transaction history while ensuring account holders have sufficient balances to cover payments and transfers originating from checks, debit cards, wire transfers, vendor billing, and more recently mobile payments. In turn, banks invest internally in compatible software and hardware, such as web functionality and check scanning, that’s intertwined and optimized to use Fiserv’s core offering.”
--Colin Plunkett, analyst
Downgrade: General Mills (GIS)
Economic Moat Rating lowered to Narrow from Wide
“We are lowering our moat rating for General Mills to narrow from wide, given our reduced conviction that the firm can report economic profits for the next 20 years in the face of secular headwinds related to evolving consumer nutritional preferences. Consumers have been eschewing processed fare in favor of fresh items found on the store’s periphery, which has slowed the firm’s category growth. However, we are confident that General Mills still has a competitive edge, as its brands remain dominant in their categories and command pricing power. We believe the firm is the leader in categories representing about a third of total food spending, which makes it a valued partner for food retailers, another aspect of its competitive edge. We also think the firm has a cost advantage, evidenced by superior margins and scale-based benefits.
We are lowering our fair value estimate to $53 per share from $57 to reflect our assumption of slightly lower volume growth and higher selling, general, and administrative expenses. With our revision to a narrow moat rating, we’ve reduced the time over which the firm is expected to earn economic profits from 20 years to 15 years. Given continued secular headwinds in the firm’s categories, we’ve lowered our long-term volume forecast to 1.2% from 1.5%. We maintain our 1.1% price/mix estimate, resulting in average organic revenue growth that falls to 2.3% from 2.6%. We’re increasing our average SG&A expectation to 7.9% of revenue from 7.1%, as we think most cost-saving opportunities are now behind the firm, although we still expect gradual improvements in the coming years due to its ability to leverage sales. As the pet and international businesses scale, we expect consolidated operating margins to improve from 2019’s 16.9% to 17.8% on average over our explicit forecast, although this is slightly lower than our previous 18.2% estimate. With the shares trading near our fair value estimate, we recommend investors await a better entry point.”
--Rebecca Scheuneman, analyst
