Beware Eroding Moats in This Fast-Changing Industry

At Morningstar, we think and write extensively about the economic moats of the more than 2,000 stocks we cover. Indeed, it is one of our central tenets that companies with moats (sustainable competitive advantages) will be able to derive economic value from those moats and that such value should be reflected in our fair value estimates. As such, we are vigilant about detecting emerging moats for up-and-coming companies and eroding moats in changing industries.

Recently, we spied a few companies in the rapidly evolving telecommunications equipment group that seemed to be suffering from eroding economic moats. Our long-standing view on moats in much of this group had been based on the extremely sticky relationships these firms had with the telecom service providers (carriers). Along with the long-term relationship, once a carrier picked an equipment firm for a network build-out--and designed the equipment into the network's backbone--additional business typically followed.

What Has Changed in Telecom Equipment
During the last five years, the industry has slowly undergone a massive change, as networks have incrementally moved from proprietary systems to Internet-based standards. In addition, the move to standards-based equipment has made it easier for carriers to source their equipment from multiple suppliers, which has increased the competitive pressures on most equipment vendors. These shifts have led us to call into question the very relationships that had underpinned our economic moat arguments for many players in the communications equipment group, particularly vendors with large legacy equipment business with carriers.

Incumbent equipment firms have seen their high-margin revenues derived from proprietary systems dry up, while their nascent Internet-protocol-based businesses still haven't scaled enough for profitability, or in cases where they have scaled, operating margins are significantly lower than they had been. Furthermore, the traditional telecom equipment vendors are becoming systems integrators, with their service businesses being the most profitable and faster-growing segments--but still typically only about 20% of sales. The situation looks even worse if we consider that in addition to the above shifts, there is hard-charging new competition coming from China and massive consolidation among service provider customers--giving carriers much greater negotiating power.

The emergence of three megavendors in the telecom equipment sector-- Alcatel-Lucent ,  Ericsson (ERIC), and  Nokia (NOK) and  Siemens (SI)--has further tilted the balance of power in the communications equipment market. These big three vendors dwarf the competition, providing end-to-end network equipment and associated service offerings. All three have sales in excess of $20 billion--more than twice the size of  Nortel  and 10 times that of  Tellabs . This increased size provides the big three greater clout with their carrier customers while also providing extensive product breadth and considerable economies of scale.

How Our Moat Ratings Have Been Affected
Taking all of this into account, we recently revised our assessment of Nortel's economic moat from narrow moat to no moat. We believe the combination of Nortel's unfavorable revenue mix skewed toward legacy equipment, the lack of scale relative to its competition, and a debt-saddled balance sheet (which limits its strategic options) have contributed to the erosion of the firm's moat.

We also took a close look at Tellabs, but we decided to maintain its narrow moat, based on the firm's large market share (roughly 80%) of equipment, which manages wireless backhaul networks among North American carriers.

Further up the telecom equipment food chain, similar changes in the competitive landscape are affecting optical component vendors. Not only are these firms exposed to equipment vendors' volatile demand cycles, but there has also been a similar shift from custom components to standardized subsystems in optical components, creating greater competition and, more often than not, negative economic returns for manufacturers. Earnings volatility and lack of visibility into business cycles have long made us skeptical about awarding moats to optical equipment vendors, but by virtue of its scale we had awarded  JDS Uniphase (JDSU) a moat. We now believe that intense pricing pressure on low-end components along with emerging vendors (such as Opnext  and Infinera (INFN)) garnering a larger share of the more profitable, high-end niches have eroded JDSU's moat. Therefore, we recently lowered JDSU's economic moat rating from narrow to none.

As we went through this process, we also reconsidered our moat assumptions on the other firms we follow in the communications equipment sector. Although we aren't making any other changes at this time, there are a handful of companies we believe warrant a mention. Ericsson, as we mentioned above, has the scale necessary for success and has become the dominant player in next-generation (3G) wireless equipment. However, we are keeping the firm at no moat for now because of maturing wireless equipment demand and our concerns that this maturation will pressure the company's margins.

Looking outside traditional telecom equipment vendors to Internet-centric communications equipment vendors, we believe that the moats of our three favorite networking companies-- Cisco (CSCO),  Juniper (JNPR), and  F5  (FFIV)--are growing. These vendors all benefit from the carrier shift to Internet-based protocols because they don't have exposure to legacy equipment spending areas.

Senior analyst Mike Ford-Taggart contributed to this article.