Why Macquarie has an advantage over its peers
Morningstar analysts recently updated several companies' economic moats, their measure of a company's sustainable competitive advantage. We put the spotlight on three stocks.
It’s been a transformative fiscal 2018 for financial powerhouse Macquarie Group: in the space of a few months it has appointed its first female chief executive and boosted its competitive advantage enough to become the newest member of Morningstar’s “moat” club.
And despite challenging demographic factors, funeral home business InvoCare has consolidated its branding and monopoly potential enough to warrant a moat upgrade from “narrow” to the elite “wide” status.
As the metaphor made famous by Warren Buffett suggests, gaining an economic moat means building a sustainable competitive advantage — qualities that allow a company to fend off competition and earn high returns on capital. A key distinguishing feature of a moat-rated company is its ability to evolve in the face of changing business conditions and new or existing competitors.
Moats don’t come easy. A solid company can carve out a sustainable competitive advantage, only to see it erode in the face of regulatory changes, new competitors, or disruption – as Sky Network Television has found in the past 12 months.
But first let’s take a deep dive into the Morningstar database to see how Macquarie and InvoCare earned their upgrades.
What are economic moats?
Macquarie: new kid on the moat block
In July this year, Macquarie Group (ASX: MGQ) made headlines by announcing low-profile company stalwart Shemara Wikramanayake as successor to long-time chief executive Nicholas Moore.
The move was universally hailed as a shrewd business move and a win for diversity as Wikramanayake, 56, born to a Sri-Lankan doctor, became only the second woman to head up a financial institution in Australian.
But even in the months leading up to the historic move, Morningstar banking analyst David Ellis had seen a rise in Macquarie’s trajectory, leading him to raise the company’s moat rating from “none” to “narrow” in April this year.
"We reassess the competitive strengths of Macquarie Group’s five business units and conclude the group does benefit from competitive advantages that are sufficiently strong to warrant upgrading the economic moat rating to narrow from no moat," Ellis said in a note to herald the move.
In Ellis’s reckoning, the group benefits from competitive advantages across its five businesses – asset management, corporate and asset finance, banking and financial services, commodities and global markets, and Macquarie capital.
But the key to the group’s strong earnings outlook is upside created from complementary activities of each business group – what Ellis calls “interconnectedness”.
"The market does not appreciate the importance of the interconnectedness of Macquarie’s adjacent businesses,” Ellis said. “But we see this as a real competitive advantage and key to continued strong growth in total shareholder returns.”
Macquarie has a fair value estimate of $130. At 3pm Sydney time, it was trading at $114.23.
InvoCare: widens the moat
It’s said that the only certainties in life are death and taxes. But for leading funeral home operator InvoCare Ltd (ASX: IVC), it’s been somewhat of an anomalous year in that Australia's death rate falling to an abnormally low level.
The long-term outlook for the business, however, is robust, according to Morningstar equity analyst Daniel Ragonese. In September 2017, he upgraded the moat from narrow to wide following a review of the company's competitive advantage - derived from its intangible assets and cost advantage.
"We believe the strong branding, reputation and in many cases, regional monopolies, will allow it to continue raising prices ahead of inflation, while building on its leading share of around 35 per cent in Australia," Ragonese said.
Among the company’s strength’s is White Lady, InvoCare's flagship brand, Ragonese says. White Lady is a unique, all-female, premium service, which costs on average up to 25 per cent more than a traditional InvoCare funeral. Ragonese expects InvoCare to capitalise on its pricing power and boost its market share.
"The service is highly sensitive in nature, and we believe consumers are willing to pay a premium to ensure they receive a high-quality service, with a provider they know and trust," he said. "In our opinion, this is the primary reason approximately 70 per cent of InvoCare’s business is generated from repeat business, or referrals."
The company's scale also adds to its competitive advantage, Ragonese says, by allowing it to spread fixed costs, across a much larger base than the smaller peers, while allocating a larger amount to marketing and advertising.
InvoCare has a fair value estimate of $16. At 3pm Sydney time, it was trading at $12.30.
Sky Network loses it edge
While Macquarie and InvoCare have shone in fiscal 2018, in the broadcast world it’s a different story as the march of video on-demand rolls on, buffeting companies like Sky Network Television (ASX: SKT).
The pace and scope of disruption in the consumer video entertainment landscape, particularly acute in New Zealand, caught Morningstar and perhaps Sky management by surprise.
The growth of tech giants like Netflix and Amazon forced Morningstar equity analyst Brian Han to strip Sky Network Television of its narrow moat status in September 2017.
"Facilitated by accelerating broadband rollout and take-up, and seduced by the low-priced, à la carte options from operators such as Netflix and Lightbox, Kiwi consumers are increasingly drawn to subscription video-on-demand, or SVOD, services, while questioning the value of paying Sky NZD80 per month for a bundle of preselected channels," Han said.
"This is clearly evident in the dramatic 15 per cent (or 129,000) fall in Sky's pay TV subscribers over the past three years."
These changes have eroded Sky's historical competitive edge, Han says. He expects top-line pressure on the company to be compounded by the continuing need to invest in content, new products and technology to defend its subscriber base, comprising both set-top-box pay-TV and new-age streaming customers.
Critically, there is also a risk of Sky losing its key competitive strength, namely, the exclusive rights to premium live sports including rugby, league, and cricket, with the entry of Amazon's SVOD service.
"Industry speculation is now intensifying on Amazon's interest in the New Zealand rugby broadcasting rights," Han said. "These rugby rights are currently the crown jewel in Sky's content arsenal (expiring at the end of 2021), and we estimate cost the group around NZD60 million per year or 17% of programming cost base.
"In our view, a loss of these rights would lead to an acceleration of pay-TV subscriber losses for Sky, as we see sports as a, if not THE, key driver of customers' willingness to maintain their relatively expensive subscriptions to Sky's traditional pay-TV services."
Sky has a fair value estimate of $2.30. At 3pm Sydney time, it was trading at $2.11.
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Emma Rapaport is a reporter with Morningstar Australia, based in Sydney.
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