Moat Busting: How New Market Leaders Are Born

I threw on a raincoat over my pajamas and ran out into the night. Was my house on fire? No. Was this a late night romantic tryst? Hardly.

I had a video that needed to be returned to my local Blockbuster (NYSE: BBI) store, and I didn't want to be stuck paying a hefty late fee. Of course this was many years ago.

At the time, Blockbuster had a seemingly impenetrable moat. What new company could establish thousands of retail outlets to compete? Little individually owned video stores went out of business in droves. Blockbuster had a pretty good thing going -- that is until someone let the water out of its moat.

Apparently I wasn't the only one who didn't like running out in jammies to beat video late fees -- and Netflix (Nasdaq: NFLX) had the perfect solution. It let you keep videos/DVDs as long as you wanted, without having to worry about additional fees. The company delivered its products to your mailbox -- and you returned them the same way. Customers didn't have to burn an ounce of gasoline in the process. And now, the company can stream video right to your house.

Netflix quickly drained the water out of Blockbuster's moat. In the past two years, shares of Netflix returned +234.2% compared with the -83.5% loss in Blockbuster's share price. In the most recent quarter, Netflix added 1.7 million new customers and grew its profits by +59% over the first quarter of 2009. Although Blockbuster won't report its first-quarter earnings until next month, analysts expect that the company will post a loss for the fourth consecutive quarter.

When a moat springs a leak, it can get pretty ugly for a one-time market leader.

Another Moat Losing Water

I thought about this as I followed the testimony of credit ratings agencies before a Senate panel on Friday. The credit ratings agencies, Moody's (NYSE: MCO), Standard and Poor's (NYSE: MHP) and Fitch, had a pretty nice moat protecting their revenue streams. Only ten agencies are designated by the Securities and Exchange Commission (SEC) as Nationally Recognized Statistical Rating Organizations (NRSROs).

The designation is lucrative because regulated investors like banks and mutual funds can only buy some kinds of bonds and financial instruments if they have been rated by a NRSRO. But even within this small group of agencies, the "Big Three" dwarfed their other competitors. Over the years, the three largest credit ratings agencies employed a business model that generated ridiculous profits. With this business model they grew far faster than their peers.

Their business model, however, involves collecting the bulk of their huge fees from the issuers of the bonds. Needless to say, the opportunity for conflict of interest is rife in the "issuer-pays" business model.

According to the Senate testimony, analysts from these companies felt pressured to give out good ratings, even to not-so-good securities. Their bosses wanted to be sure the issuers were happy, so they'd come back and pay for more ratings.

Investors who relied on their ratings suffered when the investments didn't live up to their advertised quality. And during the financial crisis, very bad investments with very good credit ratings collapsed, exposing the dangers of the "issuer pays" business model.

Enter Morningstar (Nasdaq: MORN).

Morningstar is a company that derives revenues from investor subscriptions. It has a long track record of providing its readers with solid, independent, stock and fund analysis. In December 2009, Morningstar started issuing independent credit ratings for 100 public companies with a plan to expand its coverage to include 1000 companies by year's end.

In March 2010, Morningstar bought Realpoint LLC, a credit ratings agency. It was tiny, but it was also one of the 10 designated NRSROs. Unlike the "Big Three," Realpoint didn't use an "issuer pays" model. Like Morningstar, Realpoint was an independent agency that charged its corporate clients subscription fees.

With Morningstar's size and Realpoint's NRSRO designation, this combination could become a real force in the ratings market. And with their shared independent model, catering to the investor -- and not the issuer -- the Morningstart/Realpoint union could drain some water out of the "Big Three's" moat.

Video rental customers hated Blockbuster's "late fee" business model. Institutional investors, small mom-and-pop investors, and the tax payers who had to pick up the bailout tab for mis-rated securities, all hate the "issuer pays" business model.

And when viable alternatives become available, moats begin to leak.

 
-- Amy Calistri

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