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6 downgraded global stocks worth considering

Susan Dziubinski  |  09 Jan 2019Text size  Decrease  Increase  |  
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No, the headline isn't a typo. Just because a company has been downgraded by Morningstar doesn't mean investors should sprint for the exits.

A downgrade in any one of Morningstar's measures - an economic moat rating, a fair value estimate, uncertainty - isn't a sell signal. Rather, a change indicates a recalibration of our long-term expectations. Companies that have experienced downgrades (or upgrades, for that matter) can still be undervalued or overvalued, depending on where the stock is trading relative to our fair value estimate. As a result, investors who read too much into downgrades may be missing out on opportunity.

Today we're looking for inexpensive, high-quality companies that have undergone a recent fair value downgrade. Specifically, we've screened for wide- and narrow-moat stocks with stable or positive moat trends trading in 4- or 5-star range whose fair value estimates have been cut by 10 per cent or more since 1 November, 2018. Six companies made the list.

contrarian

A Morningstar stock downgrade doesn't necessarily mean you should run for the exit

Cloud move a boon

A leading provider of relationship-management software for non-profits, healthcare organisations and educational institutions, Blackbaud has carved out a wide economic moat thanks to its high customer switching costs and intangible assets within the social good community, says analyst Andrew Lange. Last week, we trimmed the firm's fair value rating by 15 per cent.

"After reassessing our long-term view on Blackbaud's growth and margin profile, we are lowering our fair value estimate to US$87 per share from US$102," explains Lange.

"Our fair value estimate of US$87 per share implies a fiscal 2018 enterprise value/sales ratio of roughly 5 times, adjusted price/earnings ratio of 35 times, and free cash flow yield of 4 per cent. We expect Blackbaud's cloud migration to be the primary operating driver over the next several years, though the firm has already made considerable progress in this regard, with recurring revenue contributing 87 per cent of fiscal 2017 revenue and 90 per cent of estimated fiscal 2018 revenue."

Despite the fair value haircut, Lange thinks the firm's entrenched leadership position is secure, and the move to a cloud-based business model will lead to better lifetime value from customers.

Stronger position in China travel 

The largest online travel agency in China, Ctrip earns a narrow economic moat rating as a result of its strong network effect, says analyst Chelsey Tam. The firm has built a virtuous ecosystem serving both individual travelers and travel service providers, she argues. We snipped the firm's fair value by 18 per cent in November.

"We have reduced narrow-moat Ctrip's fair value estimate to USD 47 per share from USD 57 per share, and 40 per cent of the reduction was due to weakening [currency], with the rest reflecting the weak guidance during the fourth quarter, near-term weakness in travel demand due to slowing economy, increasing competition from Meituan and Fliggy, and investment in increasing customer service standard," Tam explains.

However, Ctrip has strengthened its leading position among Chinese online travel agencies and will continue to benefit from rising disposable incomes and demand for domestic and international travel.

New CEO set to unlock value

The narrow-moat conglomerate GE continues to streamline, announcing this week it will create a new independent entity consisting of its digital industrial Internet of Things offerings; it also plans to sell large parts of ServiceMax (its field service management software).

Morningstar slashed GE's fair value estimate by 16 per cent in November 2018, and stands by its US$13.70 assessment after the latest news.

"After a review of GE's 2018 third-quarter filing, we reduce our fair value estimate for GE to $13.70 from $16.30 previously," says analyst Josh Aguilar. "The primary levers in our reduced fair value estimate relate to reduced assumptions in GE's power and renewable energy segments, offset by strength in GE Aviation."

Conceding that a successful multiyear turnaround won't be easy, Aguilar argues that new CEO Larry Culp should be able to unlock GE's considerable asset value over the long term. Culp is implementing several measures including aggressive cost cutting, separating its healthcare and Baker Hughes divisions, exploring asset sales, and driving improvements to operating efficiency.

Improving fundamentals closing gap

In November, Johnson Controls announced it had reached an agreement to sell its power solutions business; the sale is expected to close by June 2019. After the sale is complete, the narrow-moat firm's main focus will be its building technologies and solutions segment, which manufactures, installs, and services HVAC systems, building management systems and controls, industrial refrigeration systems, and fire and security solutions. The sale triggered a re-evaluation of our fair value estimate, based on Johnson Controls' simplified business.

"We reduced our fair value estimate to US$46 per share following the announcement of the power solutions' sale," says analyst Brian Bernard.

He anticipates Johnson Controls' building technologies and solutions business will grow at almost 4.5 per cent compound annual growth rate over the next five years. Overall, Morningstar favours the sale and what it may do over time for the company and its stock price.

"We think a prudent capital allocation strategy in tandem with a simplified business model that is clearly showing improving fundamentals will help Johnson Controls close the gap between its current stock price and our estimate of its intrinsic value," Bernard concludes.

Headwinds favouring Tencent

Shares of the Chinese Internet giant - whose multitude of businesses include dominant social media and gaming services - were rocked in 2018, as the Chinese government stopped approving licenses for new games. As a result of the freeze and its impact on Tencent's gaming revenue, Mornignstar shaved 16 per cent off its fair value estimate.

"As a result of a pause in games approval in China, we now assume year-over-year online gaming revenue growth rate to be 6 per cent in 2018," analyst Chelsey Tam explains. "We estimate there will be a rebound in online gaming revenue growth to 16 per cent in both 2019 and 2020 as approval resumes in mid-2019."

She also believes its expected lower revenue growth will be partially offset by higher margin assumptions, given they held up better than anticipated in recent quarters.

Longer term, regulatory headwinds could work in Tencent's favor: Smaller game companies will be squeezed out, says Tam, and Tencent will be able to gain market share.

"Given wide-moat Tencent's strong network effect with 1.1 billion of monthly active users of Wechat, we believe temporary suspension of game approval and weak macro provides a good opportunity to accumulate this high-quality name," she concludes.

Under-rated network effect

Narrow-moat Weibo is the largest social media platform in China. The firm's moat stems from its network effect: It claims 392 million monthly active users and 172 million daily active users, says analyst Chelsey Tam. Morningstar lowered its fair value estimate by 12 per cent in mid-December 2018.

"We have reduced our fair value estimate for narrow-moat Weibo to $93 per share from $106 to reflect near-term macro weakness and increasing competition in the long run as mobile Internet user growth matures in China," explains Tam.

She says the rise of short-form video has put pressure on user growth and user engagement for Weibo, and some platforms have attracted content creators away from Weibo. As such, Tam expects competition to grow, which will force Weibo to invest more heavily in product development, sales, and marketing to remain competitive.

That said, Tam says its network effect remains strong: "We continue to think Weibo is undervalued for long-term investors."

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