TCS Daily


Mighty Moat

By James K. Glassman - June 3, 2003 12:00 AM

"All happy families resemble one another, but each unhappy family is unhappy in its own way," wrote Tolstoy in "Anna Karenina."

You could say the same for stocks.

All happy stocks are pretty much alike, while unhappy stocks lose their value for all sorts of reasons - fraud in the case of Enron Corp., bad mergers in the case of AOL Time Warner (AOL), inadequate business plans in the case of FreeMarkets Inc. (FMKT), whose shares have plummeted from $350 to $7 in three years.

What do happy stocks have in common? Moats.

To understand what a moat is, consider these three companies: Whole Foods Market (WFMI), Forest Laboratories (FRX) and International Game Technology (IGT). Each has at least doubled in price over the past three years, a period during which the Dow Jones industrial average has dropped nearly 2,000 points.

But first some background: When you buy a stock, you become a partner in a business. It's the business that counts, not the numbers you see every day in the stock pages, not the lines on analysts' charts. Your task is to find good businesses at good prices, or let someone else find them for you, or own an index fund whose performance reflects the market (and the economy) as a whole.

A good business is one that makes good profits - or, to be more precise, generates a consistent and substantial flow of cash over time. That cash can either be distributed to investors in the form of dividends (and we should see more of this behavior since the passage of the recent tax cuts) or kept and reinvested by the company, whose value (and stock price) will rise as a result.

Running a business is tough - and the main reason is competition, which puts constant pressure on the prices a business can charge customers. So, if you can find a business that has some protection against competition - that is, a moat - you may have found a happy stock.

"You need a moat in business," Warren Buffett, the chairman of Berkshire Hathaway (BRK.A), once said, "to protect you from the guy who is going to come along and offer [your product] for a penny cheaper."

Warfare is the prevailing environment in all sectors of the economy. It is wonderful for consumers because it means lower prices and better quality, but it can be hell for competitors. Long before the terrorist attacks of Sept. 11, 2001, the war in the airline sector was so fierce, it killed off many of its most celebrated combatants, including Eastern, Pan Am and National. Even in a good year, a company like Delta Air Lines (DAL) earns only about $5 on each $100 in sales, and those profits are depleted quickly in the purchase of new planes - all to keep up with the competition.

Airlines are commodity businesses; that is, they peddle a product, like bushels of wheat, with few distinguishing features. Consumers choose among air carriers mainly by looking at prices, so the few successful airlines - Southwest (LUV), JetBlue (JBLU) - are the ones that keep costs low. While cost cutting helps businesses thrive, it's not a moat. Eventually, competitors - even those with tough unions - cut costs too, and it's hard to boost profits. As much as I admire Southwest (I am a longtime owner of the stock), I recognize that the company is still exposed to severe competitive forces, which prevent it from raising prices and making the kind of profits that moat-protected companies make.

A moat keeps the enemy at bay. It can be a great brand name or a special way of doing business or a series of patents. In short, a moat is an attractive profit-making asset that other businesses can't easily copy. Coca-Cola (KO) is a good example - not just because of a secret formula for syrup but because of a brand name (the most recognized word in the world after "okay"), built over a century of advertising and word of mouth.

Coca-Cola stock has been a dud lately, and it may suffer in the future as global tastes change. But over time it has performed magnificently because, in its own sector, it is difficult to assail. Coke earns about 30 percent annually on its invested capital. Its book value and earnings have quintupled in the past 15 years, and dividends per share have risen from 14 cents to 88 cents. It has a gorgeous balance sheet, generates gouts of cash and has minimal capital-spending requirements.

Let's look at some other moat-protected businesses, more obscure than Coke, that have boomed in tough times:

• Whole Foods. Selling groceries is a commodity business if there ever was one, but this chain has found a productive niche. Growing by acquiring local and regional natural-foods markets such as Fresh Fields and Bread & Circus, Whole Foods owns and operates the nation's largest chain of natural-foods supermarkets - 143 stores in 25 states. Since it went public in 1992, Whole Foods has increased its cash flow, in a Beautiful Line, in every year but one. Earnings over the past decade have risen from 15 cents to $1.40 a share, and the stock has increased more than eightfold in price. Over the past 12 months it is up 7 percent, compared with a loss of 13 percent for the benchmark Standard & Poor's 500-stock index.

The moat, in this case, lies in the company's reputation for selling food, vitamins and personal-care products that customers see as more healthful than the stuff they get at Winn-Dixie or Wal-Mart. Certainly, the large chains can sell organic and natural foods too, but the consumers who buy such products are highly conscious of who is selling them. They will, it appears, pay more to shop at a place they trust. Whole Foods also competes with local natural-foods stores, but those tend to be small and not so well-stocked.

One way to tell whether a company has a moat is to look at its profit margins compared with those of its competitors. High margins mean a broad moat. In this case, Winn-Dixie (WIN), a well-run company with more than 1,000 stores, last year had a net profit margin (earnings divided by sales) of 1.3 percent. Whole Foods had a margin of 3.1 percent.

Whole Foods is still a small chain, with an average of just five or six stores per state. It could cut costs with a more efficient distribution network - especially since two-thirds of the products it sells are perishable, a big proportion for a supermarket. Are there enough customers out there for healthy groceries? Probably. But understand that one deficiency of well-protected companies is that they stake out small markets and have a difficult time expanding because demand is lacking.

Price is a consideration in any investment, and Whole Foods, with a price-to-earnings (P/E) ratio of 34, is not cheap. The good news is that the price has fallen about 15 percent in the past month while sales growth, even in a sluggish economy, remains powerful. Value Line expects both sales and earnings to rise at an annual average of 16 percent or more for the next five years. You don't get that kind of growth in this kind of industry without a moat.

• Forest Laboratories. Drug companies are classic moat-protected businesses. They spend enormous sums (an average of $900 million) to bring a drug from the lab to the market - and that investment alone provides a barrier to competitors. And once the drug is patented and approved, it has strong legal protections. Generic competitors are managing to breach patent fortifications, but, compared with most businesses, drug companies retain broad moats.

Sales of Forest's blockbuster drug, Celexa, continue to rise impressively - up 43 percent to $1.1 billion last year alone. The company also makes Aerobid for asthma and Tiazac for hypertension, among others, and it has a new anti-depressive, Lexapro, that should attract business as Celexa's patent defenses begin to expire.

Smaller drug companies like Forest have their ups and downs since they often depend on just one or two hot products - Celexa, for instance, represents nearly half of Forest's total revenue. Still, a well-managed pharmaceutical firm typically has several new medicines in the pipeline. Forest has some excellent prospects, including an Alzheimer's drug, and, even if the pipeline is dry for a spell, the company, with no debt and $1.3 billion in cash, will be able to endure.

Again, my point is not to encourage you to buy Forest but to understand how a stock can rise, as this one has, by 133 percent over three years at the same time the S&P falls 31 percent.

• International Game Technology. Gambling is a delightfully recession-proof industry. When times are good, people pour money into casinos. When times are bad, states adopt and expand lotteries. International Game Technology benefits both ways. It develops slot machines and other sophisticated gambling games, including the obnoxiously ubiquitous "Wheel of Fortune" machine, and it provides software and hardware for lotteries, now legal in 39 states and 100 countries.

IGT's moat comes from its technology. It is simply the best at what it does - making innovative games, such as progressive slot-machine systems that produce multimillion-dollar jackpots. IGT also links its machines to popular brand names, including "Jeopardy" and Elvis. Other companies can make slot machines, but no one else can make Slotopoly or Party Time. Through strong research and development, smart marketing and acquisitions of such competitors as Anchor Gaming (which readers may remember as one of my old favorites), IGT has built a 70 percent market share. When you're that big, you have pricing power.

The company's growth has been phenomenal. Earnings have risen from 8 cents a share in 1993 to an expected $4 or more this year; total revenue, from $478 million to more than $2 billion, with a net profit margin of 16 percent. Cash flow is abundant and capital-spending requirements insignificant. IGT shares have more than tripled in the past three years. They fell sharply as a result of the Sept. 11 attacks but recovered quickly. In the last year alone, they're up 45 percent.

Again, IGT isn't cheap - it closed Friday at $88.04 - but why should it be? It trades at a P/E of 23, which sounds reasonable for a company that has increased its earnings at an annual rate of more than 20 percent for the past 10 years. Growth will slow in the future - it has to - but it appears that the company's moat is awfully secure.

Reputation, patents, technology - those are just some of the moats that businesses build to protect them from marauders. No moat is permanent, and even the broadest moat can be breached by clever competitors. But, in general, a wide moat makes a happy stock - and a happy investor.
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