When Moats Collapse

This past weekend I took the family out to see Shark Tale. As an investor intrigued by the prospects of DreamWorks Animation going public -- and with a 6-year-old son who has memorized just about every line from every Pixar (NASDAQ:PIXR) movie to the point where his meager college fund is resting half in cash and half in Pixar -- it was what I like to call due diligence with a side of popcorn.

Yet before the movie even started I had come to some worrisome conclusions. I enjoyed catching the trailer to Pixar's latest flick. Next month's release of The Incredibles is promising. It's the next-to-last feature under its contract with Disney (NYSE:DIS); it's important to see Pixar finish strong on the way to its potentially lucrative independence. Yet right after that cinematic glimpse came a trailer for Robots. It's another computer-rendered animation film from the makers of Ice Age. The springtime release looked sharp and loaded with Robin Williams and his high-octane humor that served Disney so well on Aladdin. It looks like Fox (NYSE:FOX) has a winner here and that Blue Sky Studios' first hit was no fluke.

The trailer after that? It was DreamWorks Animation's Madagascar. Slated to come out over the summer as yet another computer-animated full-length feature, it got a great response from the crowd, won over by the cheeky antics of animals in a city zoo plotting their escape.

It was at this point that my wife leaned over and whispered that it seems as though Pixar is being outPixared.

OutPixared? What a bad time to tack on something new to my fragile lexicon. However, she was right. Just as Shrek 2 grossed more domestically at the box office than any of the classy Pixar epics before it, the art of high-end computer-generated animation that once seemed to be Pixar's exclusive stomping grounds had been invaded.

This doesn't mean that Pixar is toast. However, when you see the theatrical release calendar loading up with worthy distractions, it certainly closes the gap to greatness. Once you've owned a market it's awfully humbling to have to carve out thick slices to hungry rivals.

Who moved my moat?
Last week I wrote about the delicious moments in which a company throws the market a welcome curve by finding new ways to grow. This time we're looking at the other side of the coin. Just as models can explode toward the sky when things go better than planned, it can be a sobering experience to see a seemingly impenetrable moat crumble into navigable rubble.

Barriers to entry are often misunderstood. No one is going to touch eBay (NASDAQ:EBAY), even though you can buy cookie-cutter auction sites on eBay itself for less than $100. You don't even need to be immune to a better mousetrap, because I want to meet the person who claims that the best burger they ever had came from McDonald's (NYSE:MCD) or that the best soda they ever sipped was Coca-Cola's (NYSE:KO) flagship brand.

Our new Rule Breakers newsletter is aiming to seek out bold young companies that have obliterated the status quo, but the truth is that sometimes it's not the best product -- or the earliest -- but simply the smartest that wins the day.

It's true that moats aren't forever. They can be wide. They can be deep. They can be stocked with snapping crocodiles. All of that matters little if a rival's catapult is strong enough to hurl boulders your way. That's when a more important question comes into play: How strong is your castle?

Fort down and long
Pixar's castle is strong. It is right for the hip studio to go it alone come 2006 because it has no problem fully financing its endeavors, and there is no reason for the company to be cutting checks to Disney for half of the profits. Maybe Disney can stick around as a garden-variety distributor -- because both companies have a vested interest in being on good terms, given the fact that Disney will own all of the contracted characters -- but it's not the end of the world if that too goes away.

When one sees that Shrek 2 and Shark Tale are opening in more than 4,000 movie screens, while Pixar's releases are kicking off in closer to 3,200 and 3,300 screens -- and Disney's lackluster box office track record with its recent in-house feature animation stings -- it's not as though Pixar's independence will be cold and cruel.

However, those who have taken Disney to task for striking deals with upstart studios to help fill the void caused by Pixar's pending departure are also underestimating the benefits of being John Derek. If there is money to be made in mentoring -- and clearly there was in the case of Pixar -- Disney should be there to collect as a tutor.

But what will this ultimately create? The end result will be a very crowded market in feature animation. The irony is that this probably would have never happened if Pixar weren't so darn good at it. Those huge returns. Those beefy double-digit net profit margins. If that isn't the mother of all "kick me" signs, then I don't know what else it can do beyond dipping 10-Qs in honey first to attract attention. The prettier the castle, the stronger the effort to storm it.

A company like Microsoft (NASDAQ:MSFT) can do what Pixar has done, yet no one can even approach the moat in the fortressed world of operating system software. Sure, maybe in 10 years we will be talking about how it was Linux that ultimately hurled a rock toward Mr. Softy, but I don't know about that. Greed and open source don't exactly go hand in hand.

While last week's article covered the problem of underestimating a company's potential, we now see that one can also underestimate a company's competitors. They aren't always the obvious rivals; a blindside hit from behind can inflict even more damage.

So always keep an eye on what may eventually trip up your investments. A wide moat is good, but an ugly castle on the outside is sometimes even better.

Longtime Fool contributor Rick Munarriz has never found castles to be pretty, though he has kissed the Blarney Stone once or twice. He owns shares in Disney and Pixar.