Susan Dziubinski: Hello, and welcome to a special edition of The Morning Filter. I’m Susan Dziubinski with Morningstar, and I’m joined by Morningstar Research Services’ chief US market strategist Dave Sekera. Today’s episode of The Morning Filter is built around you, our viewers. Today, Dave will be answering some of the many questions viewers sent us over the past few weeks. And if we don’t answer your question, don’t lose hope. We plan to answer viewer questions more frequently each week on The Morning Filter as time permits. Dave and I are pretaping this special episode on Nov. 25. All right, Dave, you ready?
David Sekera: Am I ready? No, but let’s go ahead, and do it anyway. And I’ve got the first of my holiday mugs here to start the show off with.
Dziubinski: There you go. Sounds good. All right. Cherise had a couple of questions, Dave. First, she wanted to hear Morningstar’s view about Chinese EV Maker Nio NIO. And secondly, she asks, what it would take for the Trump administration to impose tariffs on companies like Nio. Would that move require congressional support?
Sekera: NIO is actually covered by one of our analysts out of our Hong Kong office. And to be honest, Nio is a Chinese company, and I haven’t done my homework on it, so I don’t have any commentary on the company in and of itself. I would just note that it is a 4-star-rated stock, trades at, I don’t know, close to a 30% discount to fair value. It is a company that we don’t rate with an economic moat, and it does have a very high uncertainty rating. Now, as far as tariff goes, I’m no legal expert here, but my understanding is that the president does have the authority to implement international trade agreements and treaties. It doesn’t appear that they need any congressional approval to impose tariffs and will be able to do it on his own with the stroke of a pen.
Dziubinski: All right. Now viewer Aaron has a good problem. He has some holdings that have run up more than 200%, and he’s looking for a framework to use to determine whether he should be selling these stocks or perhaps adding stop losses to them. What are your thoughts, Dave?
Sekera: It’s one of those things where knowing when to sell a stock is actually just as hard if not even harder sometimes to guesstimate as far as when to start buying a stock. And again, you know me, I like scaling in and scaling out of positions over time, but I do think that this is a good instance where I can highlight using Morningstar’s star rating system to help determine appropriate times of when to sell or conversely when to buy. For those of you who aren’t familiar, we do assign star ratings to all of those stocks under our coverage, and they go 1 through 5. One-star stocks are those that are most overvalued and trade well above a risk-adjusted margin over our long-term intrinsic valuation. Whereas, 5-star stocks are those that are most undervalued and trade well below our risk-adjusted margin from our long-term intrinsic valuation.
Now that risk adjustment is going to be based on our uncertainty rating. The greater the uncertainty, the wider range that we would allow a stock to deviate from our valuation before thinking about starting to sell it, and of course greater uncertainty then we’re looking for that stock to move further and further away before it’s a buy or sell from our intrinsic valuation. Now as a stock enters the 2-star range, it’s probably a good time to start looking at and reevaluating your original investment thesis, and think about maybe taking some profits as at that point we would expect a long-term investor would probably earn below risk-adjusted levels as compared to average returns over time. Personally, I would look to scale out of that position at that point. And then depending on the momentum, once it starts moving into a 1-star range is probably when I look to take the last of my profit and exit the position altogether.
Dziubinski: All right. Well, Manish is asking about Rio Tinto RIO. Specifically, Morningstar raised its fair value estimate on the stock on Nov. 1, and then Donald Trump won the election. Given Rio’s dependency on China, but also its ability to possibly benefit from deregulations to procure copper mines here in the US, what do we think of the stock today?
Sekera: As you mentioned, Rio’s largest customer is China. And I looked at our financial model, looks like China accounts for about 60% of sales last year in 2023. I also went through our forecast here and really tried to understand what we’re looking for going forward. And in my mind, I think our forecasts here are actually relatively conservative. I’d say kind of the overall investment thesis, the outlook is for Rio’s earnings actually to decline with the demand for many commodities, likely to soften as we get closer and closer to the end of the big economic boom in China. And of course, iron ore is going to be disproportionately hit here as it had benefited from the boom in infrastructure and real estate the most over the past couple of decades. Now, in our model, we use the two-year forward curve for pricing for commodities.
In this case, we assume iron ore is about $93 a ton through 2026, and then we start to bring that down into 2028 where our long-term price target is $70. Now, looking at copper in a similar story, it’s currently $4.20 a pound through 2026 in our model. But again, we start bringing that down toward our long-term price target of $3.65 by 2028. We’re looking for revenue to decline over the next five years. Our compound annual growth rate for revenue is a negative 2.9%. And we’re also looking for earnings to decline on that five-year compound annual growth rate of 4.2%. Yet, even after incorporating all of that into the stock and with the stock being down about 16% year to date and now trades at a 17% discount to fair value, that’s enough to put it in a 4-star territory. Plus, it looks like they pay a pretty healthy dividend yield at 7%. Now, I would caution it as a company, especially as a commodity company, that we rate with no economic moat, but it does have a medium uncertainty rating.
Dziubinski: Now, a couple of viewers have asked about Morningstar’s take on Pfizer PFE, particularly considering Robert F. Kennedy being appointed to the Health and Human Services post. The stock has a pretty attractive yield today above 6%.
Sekera: This is a really hard situation to get your arms wrapped around at this point. It is a 5-star-rated stock, trades close to a 40% discount to fair value. It’s a company we rate with a wide economic moat and a medium uncertainty. I did take a look at our outlook from Karen Andersen; she’s our equity analyst who covers Pfizer. And she noted in her most recent write-up that if his appointment is confirmed, that we may end up lowering our forecast for vaccine sales in the US. Now having said that, it looks like only 12% of the company’s sales are from vaccines in the US. And she noted that a reduction in those sales levels by in and of itself probably wouldn’t be enough to really reduce our valuation all that significantly.
The other thing that we could be looking at as another potential impact would be that they may try to implement programs to bring US drug prices closer to other international prices, other impacts that she noted that we might raise our uncertainty ratings here, which of course would widen the range around fair value that would impact our star ratings. Again, I would say this is a good one. Go onto morningstar.com, take a read through Karen’s last two notes. In her last stock analyst note following third-quarter earnings, she did note as well that just fundamentally, Pfizer is facing significant competition on several of its existing drugs, and we think that puts a lot of additional importance on Pfizer’s new drug pipeline to make up for that new competition as well.
Dziubinski: Richard points out that Morningstar has rated Kraft Heinz KHC a 4- or 5-star stock for most of the past five years. He asks, why has the market never realized the value that Morningstar sees in the company. And does Morningstar expect the market to place a value on KHC that’s more aligned with Morningstar’s in the next five years?
Sekera: That’s just an excellent observation and a great question. And I think there’s a lot of stocks that this applies to; when you look at stocks that look undervalue, they look cheap on a fundamental basis, but for whatever reason, just haven’t performed over time. In this case, I actually went and I pulled up our financial model that we had published back in December of 2019, and I compared that to where our forecasts are to where we are today. And honestly, it just looks like the company just hasn’t performed as well as we had expected five years ago. When I look at our revenue projection for this year here in 2024, that’s coming in about 8% below where our forecast was five years ago. Actually, in my mind, that’s actually a pretty good forecast if we’re within 8% over the course of the past five years.
But the real problem is where earnings are coming in? Our earnings projection for this year is currently $3 and 10 cents per share. Our projection for 2024 made five years ago is for $3 and 97 cents a share. Essentially, we’re coming in 22% below what we projected back then. Now, of course, over the past five years, we had the pandemic; we then had the supply chain bottlenecks and disruptions. We’ve had inflation. A lot of that has really hit this company relatively hard, and we see this in the food space just more general as well. But in this case, the gross margin is coming in about 80 basis points lower, SG&A is about a 100 basis points higher. So, the net result is that the operating margin is 200 basis points lower than what we had originally projected back then. Now, since December 2019, the stock’s gone up, it’s gone back down a number of times, but essentially, it’s gone nowhere over that time period, but yet, at least you’ve collected a $1.60 in dividends per year.
Approximately a 4.5% to 5% average stock yield over those past five years. Now, of course, investing is all about looking forward. What do we think now? What’s different now? Probably the biggest differential is that, in June, we upgraded the company’s economic moat rating to narrow from none. Going back in the time capsule here when Kraft was bought out by 3G Partners in 2015, 3G Partners in our view just overemphasize short-term profitability as opposed to really trying to build long-term and economic value. Now initially, that worked. And the stock did very well, its operating margin increased a lot early on, but then we started to see that stock slide in 2018 and 2019 as its brand value deteriorated as they just weren’t correctly reinvesting back into their brands. Now Erin [Morningstar director Erin Lash] who covers the stock has noted that over the past five years, Kraft has really revamped its strategy, it’s refocusing itself back on building long-term value, looking at where they can improve efficiencies, reinvesting in their brands, improving their category management, and of course to do that has required spending more money on reinvesting in those brands and innovation.
But overall, we think the company is back on the right track, and that those changes it’s made has strengthened its brands. And of course, then strengths its intangible assets, which is what the moat source here is in this case. We think that, over time, the company will be able to expand its operating margin over the course of the next decade. In fact, we have it rising from 20.2% last year up to 21.9% in 2033, which I don’t think is unrealistic. And as a comparison, the operating margin had been as high as 25.9% back in 2017 after 3G had stripped out all that brand reinvestment. Coming in at a pretty much lower margin than where it had peeked out. But in my mind, I think that looks pretty reasonable.
Dziubinski: All right. Well, we had a couple of questions come in about Berkshire Hathaway BRK.A BRK.B. Tim wants to know what we think Buffett is doing with all that cash. What changes might happen when Buffett is no longer running the show, and how the market might react to that?
Sekera: Well, actually Susan, you know what? I know you’ve covered Berkshire from your point of view for a long time now. Actually, I think that’s probably a better question suited for you.
Dziubinski: All right. Well, let me give this a whirl. This may be the first and last time we do this, Dave. As Dave mentioned, I do a lot of reporting from morningstar.com related to Berkshire Hathaway’s publicly traded portfolio. I’ll give this a try. Cash at the end of the third quarter at Berkshire was $325.2 billion, which was a record. Morningstar’s Berkshire analyst Gregg Warren, he doesn’t think that cash is being built up for any acquisition. Gregg doesn’t think that Buffett would want to make a big acquisition at this point, that could possibly tarnish his legacy. Now Gregg points out that, of course, the cash could come in handy if there is some sort of market correction, but he doesn’t think that’s actually the motivation behind the growing cash stake. Gregg actually thinks that the cash position is being built up.
Berkshire’s management has something to tap into when Buffett is no longer on the scene. The cash could be used to buy back stock and potentially pay a one-time dividend or maybe a more frequent dividend because there’s no dividend now, to keep shareholders engaged. And that sort of leads into Tim’s question about what could happen when Buffett leaves. We can’t really say what the market reaction will be. But again, Morningstar’s analyst thinks Berkshire’s culture that’s been developed there of management autonomy and entrepreneurship, really is institutionalized at this point. But he does expect that the managers who are going to follow in Buffett’s footsteps will evolve the company from this reinvestment machine that it’s been for decades, to one that’s more focused really on returning capital to shareholders. And that’s only natural when you consider the company’s size, and therefore the fewer investment opportunities it really has. Thanks for the question.
Second Berkshire question, and this one’s for you, Dave. Berkshire recently took a position in Pool POOL, which is a company that distributes swimming pool supplies and related products. Now Morningstar’s analysts don’t cover the stock, so viewers are asking, would Morningstar cover the stock simply because Buffett owns it? And then more broadly, how does Morningstar determine which stocks its analysts cover?
Sekera: We wouldn’t cover a stock just because it’s owned by Berkshire. But more generally speaking, I think our intent here is really to try and cover the greatest amount of stocks that we think are relevant to the largest proportion of our clients. Generally, we start off covering out the largest companies by market capitalization. We also look to cover as much of the main external indexes as possible like the Dow Jones and the S&P 500. And then we start to work our way down from the list there, looking for stocks that are relatively actively traded in the marketplace. And we also try and skew our coverage a bit looking for those companies that we think may have a narrow or wide economic moat. And then lastly, we will try and cover those companies that we think are good comparisons or that we think that we need to cover from a fundamental basis, in order to help make sure that we cover the right names when we’re looking at a sector overall.
Dziubinski: Now, Phil has a question about the weighted cost of capital. And specifically asking when you say, Dave, that, say for 3-star rated stocks that investors can expect a rate of return equal to the weighted cost of capital. Phil wants to know, is this number unique to each company, or is it some sort of overall assumed rate of return index to a benchmark like Treasury notes?
Sekera: And this is actually just a very good reminder to me that when I do speak, I need to make sure I’m very careful in the word choices I use when we talk. Here, in this case, for a 3-star rated stock, we would actually expect a long-term investor to earn its cost of equity, not the weighted average cost of capital. And of course, the cost of equity being one of the components along with the cost of debt and the risk-free rate that we use in our calculation to determine the company’s weighted average cost of capital. And of course, depending on its capitalization and what the cost of equity and cost of debt are, each company will have its own whack or its own weighted average cost of capital. That weighted average cost of capital then is used to calculate the net present value of the cash flow stream that we expect a company to generate over its lifetime, which then ends up being our intrinsic valuation.
Now the cost of equity in our models is going to be typically tied to how economically cyclical a company is, or really trying to make sure that we understand just how risky we think a company is over the long term. Of course, the higher the risk, the higher the cost of equity, or the greater return that the market is going to want to generate on that equity. Our different levels for the cost of equity is 7.5%. That’s for a company that has below-average cyclicality, think like utility companies are going to have lower cost of equity. 9% is our average rate, so that’s going to be for a company with average cyclicality, so just kind of the run to the mill. Typical companies under coverage are going to use that 9% rate. We get up to 11% for those companies that have above-average cyclicality or above-average risk. Think about companies like the Gap, the retailer, they’re going to be an 11% cost of equity. And then lastly, we go all the way up to 13.5%, but that’s going to be relatively rare.
That’s for a company that is going to have very high cyclicality or has idiosyncratic, specific risks to that company that we think the market’s going to want to get that kind of return over time.
Dziubinski: Well, Jim asks, “Is there any advantage to converting from a company’s common stock to its preferred stock?”
Sekera: I think the genesis of this question is we really need to understand the difference between what is a common stock versus preferred stock. Now just throwing my own opinion in there. Personally, I’m not a fan of preferred stock. I think it actually has the worst characteristics of equity and the worst characteristics of bonds, but neither of the benefits that you can get from each. Technically, preferred is equity, but preferred has a lot of bond-like characteristics. It does pay a dividend, typically it’s a fixed rate, although sometimes you see some that are floating rate. But these dividends on the preferreds can be halted, whereas a company can’t halt a payment on a bond without going into default. Now, when they halt the dividend on a preferred, usually the company’s not allowed to pay a dividend on the common equity either. They have to restart those dividends on the preferred, but again, they don’t have to restart the dividends on the preferred at any point in time until they’re ready to.
Now the other part too is that some preferreds are cumulative dividends. Those would be the ones that I would prefer. So that way, if they do halt that dividend, they have to make up for all of those that they did not pay. But a lot of preferreds nowadays don’t have that cumulative nature, so that way, you don’t get paid what you might be owed or the backdo when they do start paying it. And then lastly, if a company does go into bankruptcy or if it does default, more likely than not the preferreds are just going to get wiped out along with the common equity. I really think of preferred as being very junior subordinated that would be in the capital structure. So typically, any recovery in bankruptcy is going to go to the debt holders as opposed to the preferred. You just don’t have that same kind of protection that you might see in a bond. But at the same point in time, because you’re only limited to those dividend payments, you don’t really have a call on the company’s long-term profits.
You also don’t have the same upside potential as you do for common. Depending on what your own individual portfolio needs, I prefer common equity for that portion of the portfolio that you’re looking for, that long-term appreciation potential, and then looking directly to bonds for that fixed-income portion of your portfolio.
Dziubinski: All right. Well, John would like to know if buying dividend aristocrats would be a good strategy for protecting a portfolio during a downturn. Now, for viewers who may not be familiar, the term dividend aristocrats means stocks that have increased their dividends for 25 consecutive years or more.
Sekera: I suspect that most of those dividend aristocrats, and again, I haven’t looked through the entire list here. But I figured most of them are probably going to be pretty high-quality, relatively stable companies, companies that’ll be less volatile to the downside during a market correction. And in fact, some of them may even benefit to some degree of a flight to safety trade when that happens. And of course, the dividend income is going to be a helpful cushion to help offset any kind of principal losses during a correction. But for the most part, during a correction, depending on how long and how severe it is, even the most steady-eddy companies out there will probably face price pressures, especially when portfolio managers get to the point where sometimes they have to sell what they can sell as opposed to what they might want to.
And if it’s a steady-eddy kind of company, usually there’s going to be at least some bid for those kind of companies out there. There are other strategies out there for principal protection, maybe buying puts that can help offset losses during a downturn. But I think that’s probably maybe an interesting idea or a topic for a future show.
Dziubinski: Now, a viewer in the content section was asking about what Brazilian companies Morningstar covers. That’s your question, Dave. Do we cover any, and do any look undervalued today?
Sekera: It looks like we cover seven. Looking at these seven, Ambev is the only one that I’m familiar with. The others I don’t have any take on. But looking at the seven here, we cover Banco Bradesco, that’s a 4-star-rated stock. Itau Unibanco is 3-star-rated. Ambev looks quite attractive here at a 5-star rating. We also cover Vale, that’s a 4-star-rated stock. Petrobras, the energy oil development company down there, that’s rated 3 stars. And then two 4-star-rated stocks, Telefonica Brazil. And you know what? I’m going to murder this name. [TIM Participações] I’m not even going to try. Actually, I guess it would be Portuguese is lacking in this case.
Dziubinski: Well, it looks like a couple of opportunities. Feel free to go to morningstar.com to investigate them further. All right. Paul would like an update on a prior stock pick of yours, Baxter International BAX. The company cut its dividend in November, and it’s also divesting its kidney care business. Our analyst recently issued a new report on the company. What are some of the highlights?
Sekera: Unfortunately, I think this is going to be a relatively lengthy answer, so I hope everyone’s got their cup of coffee here. And in fact, I actually just got off the line here with Julie Utterback who covers the stock. Let me just dive into it here. Yes, we originally highlighted the stock on our May 20 show. The stock is down 5% since then. Now originally had moved up, but then it gave back all of that gain, and then some after Hurricane Helene hit at the end of September. It’s currently rated 5 stars, trades about half of our fair value. As you mentioned, the dividend did get cut there down to $0.17 per quarter. So that’s about a 2% dividend yield going forward. Company with a narrow economic moat and a high uncertainty rating. For those of you that don’t know the company, Baxter makes a wide range of medical instruments and supplies, anywhere from acute and chronic kidney failure, injectable therapies, IV pumps, and other hospital-focused offerings.
Now, this is going to be long. The company’s really had a tough time. It’s gotten hit a number of times over the past few years. Originally, in 2022, the company got hit pretty hard with supply chain issues. And then as inflation ramped up, that hit their margins pretty hard. They didn’t have very good pass-throughs in their contracted agreements, so they kind of had to eat that inflation for a while. But looking forward, we do note that a substantial number of their three-year sales contracts are coming up for renewal. As they renew those contracts, we do think they’re going to be able to better negotiate cost pass-throughs going forward then from what they had. Then early this year, they did have some issue. Their sales declined from February through April. If you remember back then, UNH, their claims reimbursement system called Change Healthcare was down due to hacking for a number of months.
Now we expected that to be temporary and normalized, and that appears to be the case when we look at third-quarter results. They were relatively solid, but then of course, the company got hit pretty hard by Hurricane Helene as it shut down their main manufacturing facility in North Carolina. Because of that, they did lower their adjusted earnings for the year to a range of $2.90 a share. That’s down from $2.93 to $3.01, but we expect that will be resolved probably in early 2025. Now the other thing that’s going on here, because it’s got to be a more complicated story than all of that, is the company is undergoing a planned divestiture of its kidney care business, which of course is going to be a lower-margin business, but there are a number of different stranded costs that the company has to eat for a couple of years, that’s going to lower their operating margin by a 100 basis points, but by 2027, the company thinks that they should be able to offset those costs.
Again, investing is all about looking forward. We do expect to see a rebound in their operating margins. We think the out margin bottomed out last year. We’re already seeing a rebound this year. We think that the combination of renegotiating those contracts, as well as divesting the low-margin kidney care business will all improve the margins over the next five years or so. Now, I would note we do expect earnings to decline in 2025, but again, that’s due to the divestiture of their kidney care business. And I think 2025 is really the number you need to gear in on as far as thinking about valuation for the company, as opposed to the 2024 earnings. And at this point, just as an indication of the value in the stock, it’s only trading at just under 13 times our 2025 earnings estimates.
Dziubinski: All right. It’s time to move on to the stock picks of the week. Your picks this week were inspired by viewer, Evan, who asked you to talk about undervalued stocks with economic moats, derived from multiple moat sources. Before we get to the picks, Dave, give viewers a rundown of the five moat sources that Morningstar has identified.
Sekera: Sure. The first is cost advantage. And again, that’s just simply as far as what company can produce goods or services cheaper than their competitors can. The second is efficient scale. It’s not often used, but again, this is where one company can effectively supply a service or a product in and of itself. Again, think about a railroad where you only need one railroad, two railroads is going to be one railroad, too many. How we have intangible assets. And again, that’s going to be patents, regulatory licenses, brands, things like that, that will allow a company to be able to charge higher prices. The network effect, this one is simply the more users that use the product or service, the more valuable the network becomes. The example here we always use is like Meta Platforms with Facebook. And then lastly, switching costs. This is where it’s just more expensive or disruptive to a business to move to a competitor than to stick with an existing provider.
Dziubinski: All right. Your first pick this week is Alphabet GOOGL. First, run us through the data.
Sekera: Alphabet is still a 4-star-rated stock. Trades somewhere close to a 20% discount to fair value. Small dividend, only a half a percent dividend yield, but it is a company we rate with a wide economic moat and a medium uncertainty.
Dziubinski: Talk a little bit about each of Alphabet’s moat sources.
Sekera: And again, I would actually just note here actually looking through all of our different moat sources, there are no companies that we cover that exhibit all five moat sources, but this is one of two companies that we think have four of the five moat sources. That being the cost advantage, specifically within the Google Cloud part of their business. The intangible assets, certainly everybody knows the Google brand and the YouTube. On the network side, Google search. The more people that use it, the better the search results end up becoming. Also, YouTube is building that network effect as well. And then lastly, switching costs. On Google Cloud, be very disruptive and very expensive for people to move away from their cloud business once they’re on it to a different cloud provider.
Dziubinski: Now, give us a little bit of an update on this one, Dave, where we stand as of when we’re taping this with the antitrust cases against Google.
Sekera: On Nov. 20, the DOJ did finally submit their proposal to the courts for remedies in Alphabet’s Google search antitrust case. And there’s a lot going on here, so I’d certainly highlight recommending going to Morningstar.com and read the full note published by our analyst in this case. The proposals here do call for a divestiture of Chrome, as well as a couple of other remedies. Just jumping to the conclusion, at the end of the day, we don’t think Chrome will be required to be divested. And even if we get to that point, there’s still a number of years away from even potentially that occurring. First, the ultimate ruling won’t come until mid-2025. We then expect the Alphabet will appeal that decision. That appeal could take at least another year, if not more. So, that will take us well into 2026.
And then even after that, we think that they will need to implement whatever other changes and remedies the courts or the DOJ are looking for. They need to try those out, see if those may or may not impact or resolve the antitrust concerns. That could take another year or two. At that point, I think we’re getting all the way out to 2029 before we could even really see whether or not they’re going to get forced to make that divestiture, which, at the end of the day, and again, there’s a lot of detail in that note as far as why we don’t think that will come to fruition.
Dziubinski: Now your second pick this week is Microsoft MSFT. Give us the details on this one.
Sekera: It’s a 4-star-rated stock. Right now trades close to a 15% discount to fair value. Again, not a very high-dividend yield, a little bit under 1%, but wide economic moat and a medium uncertainty.
Dziubinski: Now tell us how many sources underpin Microsoft’s moat and then tell us a little bit about each.
Sekera: We’re looking at three different moat sources here. The primary moat source being switching costs, but then also bolstered by secondary moat sources of the network effect and cost advantages. And we see these moat sources in multiple different parts of their different business lines. Just a couple of examples here. As far as looking at switching costs, of course, there’s a huge amount of time and expense of implementing new software packages, while at the same time, they would have to maintain the existing platform, you then have to retrain employees on new systems. As much as Microsoft is already embedded within companies' operating structures, very difficult to move off of those systems. Plus, you always have the operational risk too of changing a software vendor. Definitely, switching costs are involved here. And then other parts of the businesses, we see that network effect. For example, LinkedIn, very similar to Meta. The more people that use LinkedIn, the more valuable it becomes to all of the rest of the users. And then looking at Office 365, very large installed base, that attracts a lot of developers.
Then to create individual products like add-ins to be used for Office. And those add-ins, whether or not they’re used in Excel or some of the other products make the Office Suite more compelling and therefore it draws in even additional or more subscribers thereafter.
Dziubinski: And then your last pick this week is ASML ASML. And we’re going to need to talk about this one a little bit more in depth because we actually received a viewer question about it. But before we do, first, walk us through the numbers.
Sekera: Four-star-rated stock, right now about a 28% discount, 1% yield, company with a wide economic moat. But in this case, as a technology company, we do assign a high uncertainty rating.
Dziubinski: Which sources underpin ASML’s moat?
Sekera: First of all, I think you just have to realize with ASML, we think that they enjoy just a wide technology gap with all the rest of its competitors. They have very large investments in research and development that we think will continue to widen that moat and act as a barrier to entry. And a lot of it just has to do with the underlying business in and of itself that really they’re one of the only people that supply the type of products that they make. ASML is supported by three of the five moat sources, first being cost advantage, just as the economy of scale that they get as the world’s largest supplier of photolithography machines to semiconductors. I think they have about a 90% market share, really embeds that cost advantage. Huge amount of intangible assets, just all the intellectual property they have and the patents they have. Those just would not be able to be replicated without years of spending billions of dollars, trying to get up to their technology. And then lastly, switching costs. No one else makes like the EUV lithography machines.
And then in order to be able to move to a different photolithography machine, a customer would need to essentially redesign their existing fab or their semiconductor manufacturing facilities to accommodate that competing product, which of course would be a huge disruption and a huge cost to do so.
Dziubinski: We had a viewer named Danny ask, “Dave, what happened to ASML? The stock really tanked after reporting earnings in October, and it hasn’t recovered. Looks like it’s down about 28% since reporting. So first, unpack what ASML had to say that sort of triggered those losses.
Sekera: Two things. It is really just their guidance that they lower the top end of their 2025 revenue guidance by EUR 5 billion. It’s currently a range of EUR 30 billion to EUR 35 billion. But they also lowered their 2025 gross margin range as well to 51% to 53%. It was 54% to 56% beforehand. But we think a large portion of this guidance reduction is due to Intel postponing the opening of one of its new fabs. Also, I just have to point out here, Samsung has had its own recent technological performance. The company has acknowledged that as well. To some degree, we think that both of these firms probably have a much more cautious perspective for 2025. And I think that’s flowing through then to ASML reducing their guidance.
Dziubinski: Then, what’s Morningstar’s long-term thesis on the stock?
Sekera: As far as a long-term investor, we think the market’s probably overly fixated on the short term. Pressures coming from Intel and Samsung. Over the next five years, our top line is looking for compound annual growth rate of 10%. We’re also expanding our operating margin on better fixed-cost leverage and higher-end equipment for AI being sold. Between both of those, we’re looking for compound annual growth rate getting up to 16% over the next five years for this company.
Dziubinski: Well, thanks for your time this morning, Dave, and thanks to the viewers too for their terrific questions. Viewers who’d like more information about any of the stocks that Dave talked about today can visit morningstar.com for more details. We hope you’ll join us for The Morning Filter next Monday at 9 a.m. Eastern, 8 a.m. Central. In the meantime, please like this video and subscribe to Morningstar’s channel. Have a great week.
Got a question for Dave? Send it to themorningfilter@morningstar.com.
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