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Morningstar's Eleven: How to spot a wide-moat stock - Part 2

Lex Hall  |  23 Aug 2019Text size  Decrease  Increase  |  
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In part one of this article, we examined the eleven companies in Morningstar’s coverage that carry a wide moat rating. To earn a wide moat – or sustainable competitive advantage that would allow a company to earn excess returns for up to 20 years, we identified the five essential characteristics:

Intangible assets: these include brands, patents, or government licences that keep competitors at bay.

Cost advantage: A company that can beat its rivals by undercutting them on the price of its goods or services is deemed to have a cost advantage. On the other hand, they may sell their products or services at the same prices as their competitors but make bigger profit margins.

Switching costs: Changing from one provider to another can be a pain, which can cause a loss in productivity. “Customers facing high switching costs often won’t change providers unless they are offered a large improvement in either price or performance,” note Brilliant and Collins, “and even then, the risk associated with making a change may still prevent switching in some industries.”

Network effect: A network effect is said to occur when an increase in the users of a product or service results in a corresponding increase in mutual benefits for both old and new users. Social media giant Facebook is held to be a prime example of the network effect in action.

Efficient scale: This occurs when a market is effectively served by a small number of producers or sellers. This dynamic dissuades newcomers because their entry would result in insufficient returns for all players.

Here we examine the remaining members of the Morningstar’s wide moat club: Auckland International Airport, the big four banks, toll road owner/operator Transurban, and medical device maker Cochlear.

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Auckland International Airport's efficient scale

Auckland International Airport’s (ASX: AIA) wide moat hinges on the amount of land it has available and the monopolistic status is enjoys as an airline hub. As Morningstar director of equity research Adam Fleck notes, the company has strong efficient scale as Auckland's only international airport, and the sole major domestic jet airliner hub in the region. “Auckland is the primary entry and exit point for international travel in New Zealand, and has held this mantle for many years,” Fleck says. “We don't anticipate one of the country's other three major airports to catch up in the foreseeable future”.

AIA has nearly 1,500ha of land at its disposal, which house both the airport and developable land banks. What's more, airport regulation in New Zealand is relatively light. Consequently, AIA is free to set fees directly with airlines for passenger movements, aircraft landings, aircraft parking, check-in facility usage, and security expenses, to earn a suitable return on capital for its assets and expenditure. “While this creates significant lag in generating high returns on invested capital, as any new capital projects added to the aeronautical asset base can be priced into fees starting at the next pricing reset (generally five years), we nonetheless expect Auckland Airport to enjoy returns above its cost of capital for its regulated asset base,” says Fleck.

AIA is a two-star stock with a PE ratio of 37.8 It has a forecast dividend yield of 2.6 per cent.

Commonwealth Bank exterior view

Big four banks: A study in scale and cost advantage

Australia’s big four banks—the Commonwealth Bank (ASX: CBA), Westpac (ASX: WBC), Australia & New Zealand Banking Group (ASX: ANZ) and the National Australia Bank (ASX: NAB)—all possess wide moats. They have sustainable structural traits that guarantee high returns on equity. Together the four lenders control more than 80 per cent of the business and consumer lending markets, plus the vast majority of bank deposits. And while the banking sector is evolving, any newcomers tend to follow the majors when it comes to pricing. If there are forces eroding the wide moats of the big four, they will come in the form of increased regulatory, political and public scrutiny, says Morningstar banking analyst David Ellis. And we’ve seen as much following the damning Hayne royal commission.

But until then, the big four’s large scale ensures big cost advantages over smaller banks and nonbank lenders. “The concentrated industry benefits from high barriers to entry across most segments, making it hard for new entrants to gain any sort of foothold, particularly in retail and business banking,” says Ellis. “Foreign banks have not made a serious dent in the domestic majors' market share, while the smaller regional banks compete on service and local brand recognition but face higher wholesale funding costs than the majors and are unable to undercut on price.”

And while it has become easier and less onerous to change banks, switching is still perceived to be an inconvenience, and therefore switching costs stand as another - albeit less prominent - moat source for banks. “Most major bank customers have multiple product relationships with their bank,” says Ellis, “ensuring limited switching because of cost and time pressures.”

CBA is a three-star stock with a PE ratio of 15.4 It has a forecast dividend yield of 5.5 per cent.

WBC is a four-star stock with a PE ratio of 12.4 It has a forecast dividend yield of 6.7 per cent.

ANZ is a three-star stock with a PE ratio of 11.2 It has a forecast dividend yield of 5.9 per cent.

NAB is a two-star stock with a PE ratio of 13. It has a forecast dividend yield of 6 per cent.


Transurban: expanding its advantage

By its very nature, Transurban (ASX: TCL), one of the world’s major toll road owner/operators, possesses a strong network effect, efficient scale and competitive advantages in existing markets. “Roads benefit from being part of a network, as a new addition or an upgrade to part of the network can drive higher use of adjoining roads,” says Morningstar analyst Adrian Atkins. Transurban has a portfolio of assets in Australia and North America and has aggressively expanded its portfolio through a combination of acquisitions and greenfield projects.  The core Australian roads - such as its foundational asset, Melbourne’s CityLink and its network of seven Sydney roads - benefit from strong barriers to entry, with new entrants deterred by relatively inelastic demand and substantial upfront construction costs.

“A lack of available space and meaningful town planning restrictions further deter new entrants,” says Atkins, who estimates Transurban's current collection of toll roads will generate an equity internal rate of return of 10 per cent, comfortably above its 7.5 per cent cost of equity.

TCL is a two-star stock with a PE ratio of 82.7. It has a forecast dividend yield of 4.1 per cent.

cochlear bionic ear implant 

Left to its own devices: Cochlear

Medical device maker Cochlear (ASX: COH) has cemented its brand power as the maker of the “bionic ear”—an implant that helps people with severe to profound hearing loss when conventional hearing aids are insufficient. Cochlear has maintained a 60 per cent market share among the four players within the cochlear implant market. But the bionic ear needs expertise to install, and Cochlear’s wide moat comes from the relationship it has with developed market ear, nose and throat surgeons, who not only know and trust the brand and its products but also know how to install them.

“Cochlear is said to require exclusivity from key clinics and sees virtually no brand switching,” says Morningstar analyst Nicolette Quinn. “The installed implant market base is a captive market for its sound processor upgrades and accessories which are not compatible across brands and contribute an increasing share of revenue.”

Quinn describes this is an “annuity-like revenue stream” and forecasts it to grow from 27 per cent to half of revenues over the next 10 years. “A product recall in fiscal 2012 dented profits but had only a temporary impact on market share which is evidence of the loyalty and switching cost moat source.” Intangible assets stemming from technical product differentiation and patent protection play a lesser role in the moat. However, Quinn also points out that revenue growth for Cochlear is becoming scarcer as the core developed market children segment, about 25 per cent of annual units, is close to maximum penetration.

COH is a one-star stock with a PE ratio of 41.4. It has a forecast fully franked dividend yield of 1.7 per cent.

is senior editor for Morningstar Australia

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