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Moat-Building Mergers

Jason Stipp
Jeremy Glaser

Jason Stipp: I'm Jason Stipp for Morningstar and welcome to The Friday Five: Morningstar's take on five stories from the market this week.

Joining me with the Friday Five is Morningstar markets editor Jeremy Glaser.

Jeremy, thanks for being here.

Jeremy Glaser: You're welcome Jason.

Stipp: Lots of M&A news this week. The first story: GE won the right to buy part of Alstom, a French company, and you say this is a good thing for GE.

Glaser: It is. They are going to pay about 12 billion euros to buy the power and grid business of Alstom. This deal has been in the works for a while, but it was looking a little bit shaky. The French government was having some reservations. There were some other bids from Siemens and others who maybe were going to get into the action. But finally, with the French government taking a pretty substantial stake in Alstom, the deal is going to go through.

This makes sense for GE, because it helps them focus on the core part of their industrial business, which is where their wide moat really comes from. They'll be able to have this big installed base from Alstom. They'll be able to sell services to it, something that they're very good at. Daniel Holland, our GE analyst, says that when you look at this deal and when you look at the fact that they're going to be spinning off that North American retail finance business pretty soon, it's clear that GE really is focused on this industrials segment, which is a good thing for the company and a good thing for shareholders over the long term.

Stipp: Over in the tech sector, Oracle is agreeing to buy Micros. You say that Oracle is paying up for this deal, but Micros is a solid business.

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Glaser: It is. Oracle is paying about $4.6 billion for Micros, which makes point-of-sale and other systems for restaurants and hotels. Oracle is paying up--this is definitely a very high valuation--but it's a company that has great returns on invested capital and really solid operating margins.

Rick Summer, our Oracle analyst, sees this fitting into their strategy pretty well. Even if they are paying a lot, it does get them access to these industry verticals that they haven't seen before; maybe they can do some more selling into it, or they can continue to expand that Micros business. He thinks that overall, even if they are paying a lot, it's not going to destroy too much shareholder value, and generally it makes sense from a strategic standpoint.

Stipp: In health care, AbbVie is trying to buy Shire, and you say there is some strategic rationale, but it's really about taxes.

Glaser: We've seen some M&A that's been more strategic in nature--like we see from GE and Oracle--but this is really more of a tax move. They are not the only medical company to do this. We look at deals like Medtronic-Covidien and a bunch of other deals recently that are predicated on having a lower tax rate outside of the U.S., and a so-called tax inversion really being the big driver.

Shire is resisting this, but AbbVie says that it really makes sense for them, and they think by 2016, if they did this deal, they could have a tax rate of 13% versus 22% without the deal. It's a pretty substantial difference. You could see why they want to get it done. They also do get some diversification from Shire; strategically, it makes some sense.

And this is not the last of these inversions or attempted inversions we're going to see. I talked to Matt Coffina, Morningstar StockInvestor editor, about this, and he expects as long as this loophole is still open and before there is tax reform, which is probably not going to happen anytime soon, there could be a rush of companies trying to take advantage of these lower rates and trying to boost earnings by moving some of them outside of the U.S. to those low-tax jurisdictions.

Stipp: We also had some earnings news this week, and one of them, which was not good, was Bed Bath & Beyond. Their results really underscore the fact that this company does not have an economic moat.

Glaser: You're right. Bed Bath & Beyond's comparable same-store sales growth was only 0.4%, well below that 1% to 2.5% that they were guiding to. In addition to that, it was a highly promotional environment. Their margins were hit as they had more coupons. Everyone knows these ubiquitous 20% off coupons; they were even more ubiquitous this quarter. They are still forced to discount pretty heavily in order to get traffic into the stores and to get people to buy there.

Consumers just have very low switching costs. When it comes to buying these kind of items, they are going to go for the lowest price. If they find it lower at or at Target or Walmart, they are probably going to buy it. There's no reason that Bed Bath & Beyond would be their first or only stop. That could be challenging for the business. They are also going to open fewer stores than they had originally anticipated. It could be a challenging time for them in the near term.

Stipp: Also in earnings news, McCormick reported, and they had a flat quarter, but their moat, a wide moat, is still intact.

Glaser: I wanted to end with something a little bit spicy, but unfortunately McCormick's results are pretty bland.

They essentially had flat sales that were driven by a decline in U.S. sales and a pretty hefty increase in international sales that balanced each other out.

I think the story here is those U.S. sales being kind of weak, and McCormick is saying they are being squeezed both from private-label brands at the bottom, but also increasingly from newer brands at the top that maybe are a little bit higher end, and some consumers want to trade up.

So they are spending quite a bit of money to invest in their brands to make sure that they continue to be seen as the leader in the grocery store in a category that's still pretty fragmented.

Erin Lash, our McCormick analyst, thinks it is a savvy move for them to be investing this money and that their wide moat is very much intact. Shares are fully valued right now, but this is not the kind of business that you would really demand a huge margin of safety. So if we were to see a sell-off at any point, this is a good one for the radar screen.

Stipp: Jeremy, The Friday Five is an essential ingredient for all investors. Thanks for joining me again.

Glaser: You're welcome, Jason.

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