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One New Wide-Moat Firm, One Downgrade

Jason Stipp

Jason Stipp: I'm Jason Stipp from Morningstar. We spend a lot of time here at Morningstar thinking about companies' economic moats, this is our assessment of their competitive advantages and how long those advantages can last.

An interesting window into our economic moat thinking is to look at recent changes to moat ratings, and here with me to talk about two really interesting ones is Paul Larson. He's the editor of Morningstar StockInvestor and an equity strategist here at Morningstar. Thanks for being here, Paul.

Paul Larson: Glad to be here.

Stipp: A couple of interesting moat changes recently. The first one--kind of a timely one given that it's tax season--is H&R Block, and that was a recent downgrade. Tell me a little bit about why that went from a wide-moat to a narrow-moat company?

Larson: Well, the short version is that the alternatives are really eating into H&R Block's space, which is the retail storefront tax preparation service. Lower-cost sources of tax preparation, namely Intuit and their TurboTax product, are really taking away market share from H&R Block.

And when you look at what H&R Block has been able to achieve thus far this tax season, the total number of returns that they have prepared this year is actually down 8%, which is more than the total number of tax returns filed, which is also down about 2% or 3%.

But they are indeed losing market share and they have been losing market share, and we don't think that the competitive dynamics in the industry--the alternatives--are really going to change and this is a company that's going to continue to lose market share.

Stipp: So is this one of those stories where maybe we were a little too optimistic when we originally looked at the stock, or is it one of those where it was a wide moat at one time and then over time it just starts to lose a little bit of its edge?

Larson: I think at one time it was a wide-moat stock, but as the population becomes more computer savvy and those alternatives start to gain some traction, I think that over time the value-add by H&R Block has decreased.

I would say that even though it's no longer a wide-moat company, it is still a narrow-moat company; it's still a relatively good firm, all things considered. We just don't think it's that top decile in terms of quality anymore.

Stipp: So the second company is also an interesting one. It's in commercial real estate, an area of the market that a lot of people are wringing their hands about. It's called CoStar and it was recently upgraded to wide moat. Tell me a little bit about the story behind this company?

Larson: Right. This is indeed a commercial real estate company, but they don't own commercial real estate. They're an information company and they own a database regarding commercial real estate transactions and tenants.

And it's really an indispensable resource for those operating in the commercial real estate space. Whether you're buying or selling, investing in or looking to rent a commercial real estate, they own critical information.

And the reason that this company has a moat is the network effect. People are drawn to this service and the more users this service garners, the better the information becomes and the more attractive it is. And this is a company that's more than twice as large as its next largest competitor LoopNet.

Now in terms of what's been going on lately: When we first picked up the company, we were worried like everyone else about what was going to happen in the commercial real estate space, and we were thinking that this company was really going to be hurt in terms of profitability. Well, frankly, that has not panned out.

The renewal rate for this company is still right around 85%. That's what it was in 2009 and that's a very high renewal rate. Even in 2009, which was a very tough year for commercial real estate, the returns on invested capital are in excess of 20% with goodwill and over 40% if you strip out that goodwill. So definitely a very solid company with high profitability, and we think it has a wide moat.

Stipp: So obviously with any new wide-moat company on the list, we are wondering, is it a buy today? What's the fair value look like?

Larson: The fair value estimate is $48, and like a lot of other wide-moat stocks, it's not at a great discount to that fair value estimate. The stock is only right around $41. So right now I think this is a company for the radar and not necessarily one to buy at this point.

Stipp: Well, great. Thanks for the information on these two moat changes, Paul.

Larson: Thanks for having me.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.