Editor's Note: Since the filming of this video, Morningstar equity analyst Matthew Coffina was named editor of Morningstar StockInvestor.
Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We spend a lot of time here talking about economic moats, or long-term competitive advantages. I'm here with Paul Larson. He is the editor of Morningstar StockInvestor. He is our chief equities strategist, and he is also in charge of our economic moat research. We are going to look at a few new firms that have been recently given the wide-moat rating and a few that have lost it.
Paul, thanks for joining me today.
Paul Larson: Thanks for having me.
Glaser: Let's start with the additions to the wide-moat cohort. What's the first one?
Larson: One company that we recently upgraded to a wide economic moat rating is Rockwell Automation. And what this company has, is they have a platform that basically controls a lot of the automation that happens at factories. And once a factory gets on the Rockwell platform, there are very significant switching costs to go from one platform to another. So, once they have this platform, they tend to stick with it for a long period of time, and that gives Rockwell some fairly significant pricing power.
And another thing to consider is that the automation within a factory is a relatively small cost of the overall cost of running a factory. So, that also gives this company some pricing power. But the proof is really in the pudding when you look at the returns on invested capital. They're very safely above the cost of capital for this company and have been for a number of years. And that's a situation that we expect to continue relatively far into the future.
Glaser: Let's take a look at the pharmaceutical space. We recently promoted one to wide moat and are going to take a wide-moat rating from another firm. Can you talk about why those two stories have diverged?
Larson: Sure. Well, maybe we can talk about the upgrade first and a company that we recently upgraded is Baxter, which is a diversified health-care firm. And what is really catalyzing the upgrade here is actually a recent acquisition of a company called Gambro and this deepened Baxter's platform in a couple of disease therapies, namely, blood diseases. This is a company that has some strong expertise there now.
But when you look at the other company that we're downgrading, Abbott Laboratories, this is a company that is about to split into two firms. AbbVie, which is their patented pharmaceutical business, we might as well call it Humira Corp. because they have this one blockbuster drug and this is going to generate a majority of this particular company's earnings once the split happens.
The other part of Abbott, the so-called new Abbott, is going to be some of the slower-growth but steadier businesses like the nutrition business, the diagnostics business. But when you look at Abbott, when you split the two, the AbbVie unit is going to have a ton of cash flow over the next couple of years. But the long-term competitive advantage after Humira loses patent protection is very uncertain. So, that firm by itself has a narrow moat.
Meanwhile the other businesses, the new Abbott also is a collection of narrow-moat businesses as well that are going to be strained for near-term cash flow, that they need to really take it to the next level in terms of growth and competitive advantage. So, the split at Abbott actually, from a moat perspective, we think is going to destroy value.
Glaser: We also have one more downgrade on the technology sector. Can you tell us a little bit about that?
Larson: Sure. Another company that we downgraded is a company called Micros, and this is a company that makes software applications for use in the restaurant and hospitality business. You may have seen, if you're eating out at a restaurant, the servers interact with this and it controls the billing.
It's a relatively sticky business in that the renewal rates are relatively high, but we do see some disruptive threats on the horizon. One primary competitor completed an acquisition and is going to have a much larger market share, be a stronger competitor. Also, there are some disruptive threats on the horizon, such as cloud and mobility. You have service providers, like Square and even someone like PayPal, looking to get into the space. So, we thought that a narrow economic moat was a more appropriate rating than the wide-moat rating because the future 10-20 years out is a little bit cloudy right now.
Glaser: Paul, thanks so much for the update.
Larson: Thanks for having me.
Glaser: For Morningstar, I'm Jeremy Glaser.
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