6 Downgraded Companies to Consider

No, the headline isn't a typo. Just because a company has been downgraded by Morningstar doesn't mean investors should sprint for the exits.

A downgrade in any one of Morningstar's measures--an economic moat rating, a fair value estimate, uncertainty--isn't a sell signal. Rather, a change indicates a recalibration of our long-term expectations. Companies that have experienced downgrades (or upgrades, for that matter) can still be undervalued or overvalued, depending on where the stock is trading relative to our fair value estimate. As a result, investors who read too much into downgrades may be missing out on opportunity.

Today we're looking for inexpensive, high-quality companies that have undergone a recent fair value downgrade. Specifically, we've screened for wide- and narrow-moat stocks with stable or positive moat trends trading in 4- or 5-star range whose fair value estimates have been cut by 10% or more since Nov. 1. Six companies made the list.

Blackbaud

BLKB

Fair Value Change: -15%

Economic Moat: Wide

Moat Trend: Stable

Morningstar Rating (as of 12/13/18): 4 stars

A leading provider of relationship-management software for nonprofits, healthcare organizations and educational institutions, Blackbaud has carved out a wide economic moat thanks to its high customer switching costs and intangible assets within the social good community, says analyst Andrew Lange. Last week, we trimmed the firm's fair value rating by 15%.

"After reassessing our long-term view on Blackbaud's growth and margin profile, we are lowering our fair value estimate to $87 per share from $102," explains Lange. "Our fair value estimate of $87 per share implies a fiscal 2018 enterprise value/sales ratio of roughly 5 times, adjusted price/earnings ratio of 35 times, and free cash flow yield of 4%. We expect Blackbaud's cloud migration to be the primary operating driver over the next several years, though the firm has already made considerable progress in this regard, with recurring revenue contributing 87% of fiscal 2017 revenue and 90% of estimated fiscal 2018 revenue."

Despite the fair value haircut, Lange thinks the firm's entrenched leadership position is secure, and the move to a cloud-based business model will lead to better lifetime value from customers.

Ctrip.com ADR

CTRP

Fair Value Change: -18%

Economic Moat: Narrow

Moat Trend: Stable

Morningstar Rating (as of 12/13/18): 4 stars

The largest online travel agency in China, Ctrip earns a narrow economic moat rating as a result of its strong network effect, says analyst Chelsey Tam. The firm has built a virtuous ecosystem serving both individual travelers and travel service providers, she argues. We snipped the firm's fair value by 18% in November.

"We have reduced narrow-moat Ctrip's fair value estimate to USD 47 per share from USD 57 per share, and 40% of the reduction was due to weakening [currency], with the rest reflecting the weak guidance of 0% to 1% non-GAAP operating margin in the fourth quarter, near-term weakness in travel demand due to slowing economy, increasing competition from Meituan and Fliggy, and investment in increasing customer service standard," Tam explains. That being said, Ctrip has strengthened its leading position among Chinese online travel agencies and will continue to benefit from rising disposable incomes and demand for domestic and international travel.

"In the long term, we think the margin expansion story remains as the higher margin international business will increase in business mix, Ctrip gains bargaining power against hotels, and operating leverage increases over time," she concludes.

General Electric

GE

Fair Value Change: -16%

Economic Moat: Narrow

Moat Trend: Stable

Morningstar Rating (as of 12/13/18): 4 stars

The narrow-moat conglomerate continues to streamline, announcing this week that it'll create a new independent entity consisting of its digital industrial Internet of Things offerings; it also plans to sell large parts of ServiceMax (its field service management software). Back in November, we sliced GE's fair value estimate by 16% and stand by our $13.70 assessment after the latest news.

"After a review of GE's 2018 third-quarter filing, we reduce our fair value estimate for GE to $13.70 from $16.30 previously," says analyst Josh Aguilar. "The primary levers in our reduced fair value estimate relate to reduced assumptions in GE's power and renewable energy segments, offset by strength in GE Aviation."

Aguilar admits that a successful multiyear turnaround won't be easy but argues that new CEO Larry Culp should be able to unlock GE's considerable asset value over the long term by aggressively cutting costs, separating of healthcare and Baker Hughes, exploring asset sales, and driving improvements to operating efficiency.

Johnson Controls International

JCI

Fair Value Change: -13%

Economic Moat: Narrow

Moat Trend: Stable

Morningstar Rating (as of 12/13/18): 4 stars

In November, Johnson Controls announced it had reached an agreement to sell its power solutions business; the sale is expected to close by June 2019. After the sale is complete, the narrow-moat firm's main focus will be its building technologies and solutions segment, which manufactures, installs, and services HVAC systems, building management systems and controls, industrial refrigeration systems, and fire and security solutions. The sale triggered a re-evaluation of our fair value estimate, based on Johnson Controls' simplified business.

"We reduced our fair value estimate to $46 per share following the announcement of the power solutions' sale," says analyst Brian Bernard. "Over five-year explicit forecast horizon, we model Johnson Controls' building technologies and solutions business growing at almost a 4.5% compound annual growth rate, with adjusted EBITA margin improving from 13.7% in fiscal 2019, to 15.3% in 2023."

Overall, we're in favor of the sale and what it may do over time for the company and its stock price.

"We think a prudent capital allocation strategy in tandem with a simplified business model that is clearly showing improving fundamentals will help Johnson Controls close the gap between its current stock price and our estimate of its intrinsic value," he concludes.

Tencent ADR

TCEHY

Fair Value Change: -16%

Economic Moat: Wide

Moat Trend: Stable

Morningstar Rating (as of 12/13/18): 4 stars

Shares of the Chinese Internet giant--whose multitude of businesses include dominant social media and gaming services--have been rocked this year, as the Chinese government stopped approving licenses for new games. As a result of the freeze and its impact on Tencent's gaming revenue, we shaved our fair value estimate by 16%.

"As a result of a pause in games approval in China, we now assume year-over-year online gaming revenue growth rate to be 6% in 2018," analyst Chelsey Tam explains. "We estimate there will be a rebound in online gaming revenue growth to 16% in both 2019 and 2020 as approval resumes in mid-2019. Our assumption of lower revenue growth is partially offset by higher margin assumptions as margins hold up better than our expectations in recent quarters."

Longer term, regulatory headwinds could work in Tencent's favor: Smaller game companies will be squeezed out, says Tam, and Tencent will be able to gain market share.

"Given wide-moat Tencent's strong network effect with 1.1 billion of monthly active users of Wechat, we believe temporary suspension of game approval and weak macro provides a good opportunity to accumulate this high-quality name," she concludes. "Tencent's repurchase of 2.8 million shares is a testimonial of our view."

Weibo ADR

WB

Fair Value Change: -12%

Economic Moat: Narrow

Moat Trend: Stable

Morningstar Rating (as of 12/13/18): 4 stars

Narrow-moat Weibo is the largest social media platform in China. The firm's moat stems from its network effect: It claims 392 million monthly active users and 172 million daily active users, says analyst Chelsey Tam. We lowered its fair value estimate by 12% this week.

"We have reduced our fair value estimate for narrow-moat Weibo to $93 per share from $106 to reflect near-term macro weakness and increasing competition in the long run as mobile Internet user growth matures in China," explains Tam. "The rise of short-form video has put pressure on user growth and user engagement for Weibo, and some platforms have attracted content creators away from Weibo." We expect competition to grow, which will force Weibo to invest more heavily in product development, sales, and marketing to remain competitive.

That said, its network effect remains strong.

"We continue to think Weibo is undervalued for long-term investors," she concludes.