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By Jason Stipp | 11-11-2010 03:46 PM

A New Wide-Moat Find for European Investors

This European-listed firm's employee lunch voucher program enjoys a dominant competitive position and benefits from a strong network effect.

Jason Stipp: I'm Jason Stipp from Morningstar. We recently picked up coverage of a new company, a spin-off overseas, that's interesting because it's also a wide-moat firm.

Here with me to talk about some of the attributes of this company is Morningstar's Paul Larson, editor of StockInvestor newsletter and also an equity strategist.

Thanks for joining me, Paul.

Paul Larson: Thanks for having me again.

Stipp: So this is an interesting company. First of all, can you tick off some of the high level things that really made this company catch your attention?

Larson: Well, it is interesting, one, because it's a fairly small company, only about a $4 billion market cap, and most of our wide-moat firms tend to be very large companies, so it's a bit unique in that aspect.

Also, this is a company that is benefiting from one of the most powerful sources of economic moat, and that is the network effect. And whenever you can find a network effect business, I think it's worthy of paying attention to.

Stipp: Sure. So, before we get into some of the things that make it a wide-moat firm, let's talk a little bit, first about this company's business-to-business model, what the company is, what it does, and so we can get a sense of the background there?

Larson: I haven't even mentioned the name, yet. It's Edenred, and what this is, is it's a benefits provider, primarily in Europe. And their main program is Ticket Restaurant, and what this is, is a voucher program that companies can give vouchers to their employees to use at local restaurants, because paying for lunch is a fairly common benefit that many European companies give, and the reason that the voucher program came about is that many larger companies have company cafeterias, and this is a tax-deductible benefit for the company because they incur the expense. But if you're a smaller company, if you only have a dozen or two employees, you can't afford to have that cafeteria, but what you can do is you can buy these vouchers, which are of course tax deductible, give them to the employees, and then they can run out and use these vouchers to buy lunch.

The interesting thing is that the voucher programs benefit from a network effect. There's really only two voucher programs that have scale in the EU and that is Edenred's program and then another one run by Sodexo. And the network effect here is that the restaurants are only going to take vouchers that have a critical mass; they are only going to deal with one or two of these voucher programs, and so they have over 1 million restaurants that are signed up on their network.

And then the employers are also only going to buy the vouchers where you have a critical mass of restaurants that are accepting them. So, it's that network effect where you have the most employers and the most restaurants, and it's very, very powerful barrier to entry into the market.

Stipp: So you mentioned that there was one competitor here. Is this a situation where they can pretty comfortably have a duopoly and both operate reasonably together and kind of corner the market on this as two companies?

Larson: Yeah, I think you hit the nail on the head. What this is, is an oligopoly, and it's very similar to what we have with the MasterCard and Visa, where you have these two very powerful payment networks benefiting from the network effect. And they compete around the edges, but the business model is so powerful that they both have very high profitability, both in the payment networks of Visa and MasterCard, as well as with these vouchers.

Stipp: Sure. So it sounds like a strong business model for the company. What do the economics say, how is that translated to profits for the firm?

Larson: Very, very high profitability. The qualitative aspects of the moat analysis are certainly backed up by the quantitative financials. Gross margins close to 90%, operating profit margins in the 35% to 40% range, returns on invested capital close to 50%; these are all very, very high metrics in terms of profitability.

Stipp: Truly indicative of a wide-moat.

Larson: Yes.

Stipp: So what are risk factors here? It sounds like they have a strong business; they have a good market that they are dominant with. What things should be on an investor's radar if they're worried about the future. What things would keep you up at night, for example?

Larson: Well, I think, there's really only one main risk, and that is the potential for change in the tax regime in the markets that they operate, because if suddenly these vouchers are no longer deemed to be tax deductible by the tax authorities in France or Italy or something like that, that would obviously blow a hole in this business model. I don't think that that is a likely effect. It's a very low probability event, but very high impact were it to actually come true.

Stipp: Sure. So, what's the valuation look like for it? This is a company that's listed in Europe. So for European investors, does it look like it's a good buy for them?

Larson: Right now, it looks like it's only mildly undervalued. Our fair value estimate is €18, and the stock is a little bit under €17 as we film this, so it's mildly undervalued. It was more undervalued when it first came out, when it was first spun out, but the stock has indeed run in recent months, so I think this is the one just for the radar at the moment.

Stipp: Certainly an interesting idea for our European viewers and European investors. Thanks so much for joining me, Paul.

Larson: Thanks for having me.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.

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