7 Wide-Moat Stocks to Avoid--For Now

Regular readers of this column know that Morningstar has a thing for moats. We think that companies that have established significant competitive advantages--or in our parlance, that have dug moats--can better withstand competition and earn high returns on capital for years to come.

However, valuation matters, too. As a result, we can be positive on a company but negative on its stock. Sure, our analysts may suggest on occasion that investors pick up shares of particular wide-moat companies that are fairly valued by our metrics. But you'd be hard pressed to find anyone at Morningstar who thinks it's a good idea to buy a wide-moat stock trading in 1-star range.

For this week's screen, we decided to look for overvalued large companies with wide moats. Specifically, we homed in on stocks trading in 1-star territory that also landed in the large-cap area of Morningstar's style box.

Seven stocks made the list. While these companies may be overpriced today, they may be suitable watchlist candidates--though given how significantly overpriced some of these names are, investors may be "watching" for a while.

Automatic Data Processing

ADP

Premium to Fair Value Estimate (as of 9/11/18): +53%

Uncertainty: Medium

Automatic Data Processing is the largest provider of payroll services in the United States. We assign ADP a wide moat thanks to high switching costs, says analyst Colin Plunkett.

"The incremental investment required to add a new customer or an employee to a platform is small, which in recent years has resulted in high incremental returns and margins," he explains. "Most of ADP's growth results from a growing labor market."

Moreover, increased regulation, tax complexity and the Affordable Care Act have created additional revenue opportunities for payroll service providers--and have allowed them to strengthen their grips on their customers.

"Given the sometimes daunting compliance and reporting requirements, human resources departments often do not risk substituting their payroll service provider out of fear it could result in errors that could lead to fines," Plunkett notes.

That said, we think ADP faces some challenges, including a legacy technology platform and increasing competition.

"We think ADP has significant reinvestment needs and cost pressures," concludes Plunkett.

We peg ADP's fair value at $96; shares were trading $50 ahead of that as of this writing.

Cintas

CTAS

Premium to Fair Value Estimate (as of 9/11/18): +79%

Uncertainty: Medium

Cintas is the largest provider in the route-based uniform solutions industry, with an approximate 33% market share. Its massive distribution network has led to industry-leading efficiency and margins, says analyst Matthew Young.

"Our wide moat rating for Cintas stems from its core uniform rental and facility services operations (81% of sales), which enjoy significant scale-based cost advantages," explains Young. Granted, uniforms are somewhat commodified apparel products. But as Young details, scale matters in this route-based service business, because it provides greater leverage over a vast fixed-cost base and creates barriers to entry.

"It would be quite difficult for a new entrant or small provider to replicate Cintas's broad network reach--an operation would incur significant losses until building sufficient route density, particularly given the need to run scheduled routes while investing in delivery trucks and rental processing facilities," he adds.

The firm's operating profitability has been impressive.

"This is no secret among investors and the shares consistently trade at a healthy premium to our fair value estimate," concludes Young.

Costco

COST

Premium to Fair Value Estimate (as of 9/11/18): +40%

Uncertainty: Low

Costco differentiates itself among retailers with a warehouse club model that sells a limited selection of product in bulk in a no-frills shopping environment. We estimate that the retailer generates about three fourths of its operating income from membership fees and the rest from below-average markups on merchandise, says analyst Zain Akbari.

"Costco has built a model that strikes us as insulated from the e-commerce and retail troubles that plague other retailers in its space," he argues. "From our vantage point, the use of fresh food and gas as loss leaders should enable Costco to preserve its market share, withstanding competition from other discounters and online players like Amazon."

The retailer's wide moat stems from a cost advantage and its strong brand, which is associated with high quality and low cost, says Akbari. Nearly 94 million members pay annual fees--and shopper frequency is likely elevated because customers want to justify those fees, he adds. Moreover, the retailer was able to raise annual fees in 2012 and 2017 while still holding retention rates around 90%.

Morningstar tags Costco with a $175 fair value estimate. Shares trade nearly 40% above that today.

Dassault Systemes SE

DASTY

Premium to Fair Value Estimate (as of 9/11/18): +59%

Uncertainty: Medium

Dassault develops product lifecycle management (PLM) offerings that help businesses operate more efficiently and align processes properly. The firm's wide moat results from high switching costs and network effects, says analyst Andrew Lange.

"The technical nature of the company's flagship design software means customers are opposed to switching to rival platforms given the time it takes to learn a new product, the risk to operational downtime, and the cost to implement a new solution," he explains. The company's strong competitive position in the PLM software market is supported by more than 10 million users, and we expect it to hold its competitive position over time. Moreover, expansion into underpenetrated emerging economies should drive top-line growth.

Despite its rosy prospects, we think shares are overpriced: We assign a fair value estimate of $94 to the stock; shares are trading around $150.

"With the stock trading at a large premium to our valuation, we'd seek a significant pullback before considering it for investment," warns Lange.

Ferrari NV

RACE

Premium to Fair Value Estimate (as of 9/11/18): +80%

Uncertainty: Medium

Few brands exude luxury more than Ferrari.

"Among car enthusiasts, the Ferrari name conjures images of incredibly fast, highly exclusive, strikingly beautiful vehicular art," says senior equity analyst Richard Hilgert in his latest report. Indeed, Ferrari's wide economic moat can be traced to intangible assets that include brand strength and intellectual property.

"Gross margins exceeding 50%, EBITDA margins in excess of 25%, and returns on invested capital in the upper teens to low 20s are all metrics that are commensurate with luxury goods companies and support Ferrari's wide moat rating," adds Hilgert. The long-term stability of Ferrari's revenue, addressable market growth, expansive profit margin, and solid returns on invested capital throughout economic cycles are compelling reasons to invest at the right price.

"Like the rich heritage of the Ferrari brand, we think Ferrari stock will regularly trade at a rich, luxury-goods-type valuation, owing to its wide economic moat," says Hilgert. "While we would not be averse to paying up for a wide-moat company like Ferrari, we view this stock as too overvalued relative to our forecast for Ferrari’s healthy cash flow generation and superior returns on invested capital."

Intuit

INTU

Premium to Fair Value Estimate (as of 9/11/18): +67%

Uncertainty: Medium

Intuit has developed an entrenched market-leading position in self-prepared tax and small- to midsize-business accounting software, and has carved out a wide economic moat.

"Key to the company's success have been the inherent switching costs and network effects associated with its software," explains Lange. "Shifting to alternative software costs customers the time and effort required to learn a new product, additional training costs, operational disruption, and the risk of transferring business-critical data. Moreover, Intuit has strengthened the stickiness of this relationship by skillfully intertwining the functionality of its multiple products, such as payroll, making users more likely to adopt additional products as their needs expand."

The company posted impressive results in August, and announced that CEO Brad Smith will step down at the end of this year, to be replaced by executive vice president Sasan Goodarzi.

"We're encouraged by this wide-moat name's ability to maintain increasing online subscriber growth and we do not expect the C-level switch to jolt the company's strong financials," noted Lange in response to the news.

We value Intuit at $135; shares are trading well north of $200 as of this writing.

"We continue to view the stock as overvalued," concludes Lange.

Intuitive Surgical

ISRG

Premium to Fair Value Estimate (as of 9/11/18): +99%

Uncertainty: High

The medical equipment maker has developed a robotic system for minimally invasive surgeries--and procedure growth has been through the roof. Thought here has been some deceleration in growth among mature procedures, we expect total procedures to triple during the next decade. Robotic surgery has ample room to grow, argues regional director Alex Morozov.

"The ceiling is virtually unlimited, with existing applications of robotic surgery only scratching the surface of all possible procedures that could migrate to the robot over the next decade," he explains. "Urology, gynecology, general surgery (colorectal, hernia, and others), and cardiothoracic all still offer sizable unpenetrated and underpenetrated opportunities, both in and outside the United States." He calls the wide-moat company’s competitive positioning "superb" and its growth profile "healthy."

That said, Morningstar pegs the firm's fair value at $275; share are trading at almost twice that amount.

"The company is now trading at 15 times its 2018 sales and nearly 50 times earnings, well above its historical highs," notes Morozov in his latest report. "We remain bearish on the company's shares."