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Week in Stocks: Strong Results from a Top Energy Pick

Plus, Berkshire posts blowout quarter, student lenders sell off, and more.

Jeffrey Ptak, 11/13/2006

Morningstar's 100 stock analysts cover 1,800 companies. Their full analyst reports are available through Morningstar Principia Stocks Advanced and Morningstar Advisor Workstation Office Edition.

Morningstar analyst Catharina Milostan, Pioneer Natural Resources PXD took another step toward targeted 10%-plus production growth in 2007 with a strong fiscal third-quarter showing.

Net income from continuing operations surged 30.6% from the year-ago quarter, and accelerated drilling in North America spurred 3% production gains during the quarter from the first half of 2006. Encouraging as these results are, Milostan believes the outlook for drilling activity over the next few years is a more telling measure. On that front, Milostan sees mounting evidence that Pioneer's shift to lower-risk onshore North American properties--the company has expanded to 40 rigs in North American from only 23 at year-end 2005--will net more-consistent, drilling-driven production gains.

In addition, Milostan notes that Pioneer remains on track to start up major projects in 2007 and 2008, including its South Coast Gas project in offshore South Africa and Oooguruk project on the North Slope of Alaska. In short, the story is playing out as Milostan had forecast. Thus, she's leaving her fair value estimate unchanged.

Berkshire Earnings Climb
On Friday, Berkshire Hathaway BRK.B reported earnings of $7.4 billion through the first nine months of the year, exceeding Morningstar analyst Justin Fuller's expectations.

Improved profitability in the reinsurance businesses, thanks to a very quiet Atlantic hurricane season, drove earnings. Even though profiting from catastrophe reinsurance this year now looks like it was shooting fish in a barrel, Fuller thinks Berkshire's success was due to its strong appetite for risk and fortress-like financial strength. In his view, these competitive advantages allowed the conglomerate to charge higher prices and take on more catastrophe exposure, while most other reinsurers were running for cover.

Berkshire's other businesses also delivered good results, in Fuller's view, as auto insurer Geico's premiums climbed 9.9%, helping Berkshire's overall cash balance swell to more than $42 billion. In view of these strong results, Fuller plans to increase his fair value estimate for each Berkshire Class B share.

Election Dings Student Lenders
In what Morningstar analyst Ryan Batchelor thinks is an overreaction, investors sold off a pair of student lender stocks, Sallie Mae SLM and Student Loan Corporation STU, on Wednesday.

The sell-off reflects apparent fears that a Democrat-led Congress would seek to reduce benefits the government doles out to student lenders, thereby diluting the earnings power of these firms. While Batchelor thinks tighter legislation may eventually be passed, he'd already expected government benefits to decline over time, and does not think it will materially impair the long-term value of these businesses. In fact, Batchelor thinks that legislation could have the unintended effect of strengthening Sallie Mae and Student Loan Corp's competitive standing by making the economics of student lending that much more tenuous for smaller lenders.

In addition, Batchelor observes that Sallie and Student Loan Corp have been diversifying their revenues away from an exclusive reliance on federally backed student loans. As such, he is sticking with his fair value estimates for both firms for now. 

Newspapers Team Up with Google
Publishers of more than 50 major newspapers are set to begin a three-month trial of selling advertising through Google's GOOG Web site. The agreement allows about 100 of Google's advertisers to place bids for ads in newspapers in an attempt to make the process of buying print ads easier.

Morningstar analyst James Walden sees the alliance as a positive development for the newspaper publishing industry because, if it proves successful, newspapers could eventually gain exposure to Google's entire advertising base. The agreement also gives publishers a significant amount of control, allowing them to set minimum prices and the ability to choose which ads to run and when.

Nevertheless, Walden thinks that until the success of the test can be gauged, the ultimate impact of the alliance on newspaper publishers will remain difficult to quantify. Thus, for the time being, Walden doesn't plan to change any fair value estimates for the newspaper publishers he covers.PAGEBREAK

Abbott Laboratories to Acquire Kos Pharmaceuticals
The recent spate of acquisition activity in the pharmaceutical industry continued last week when Abbott Laboratories' ABT announced it would acquire Kos Pharmaceuticals KOSP in a $3.7 billion deal.

In Morningstar analyst Heather Brilliant's opinion, Abbott is paying a hefty premium for Kos and its niche products in cholesterol and inhaled treatments. Brilliant had always been concerned that larger pharmaceutical companies would threaten Kos' products in the long run, particularly in the HDL-raising cholesterol niche. However, with Abbott's resources backing up these products, Brilliant thinks the combined entity may be able to protect Kos' competitive position and deliver more sales with existing and potential products. However, Abbott will have to significantly extend the reach of Kos' products to make the deal a resounding success.

In view of the preceding, Brilliant raised her fair value estimate for Kos to the offer price (which is all-cash), though she doesn't expect any major changes to her fair value estimate for Abbott, as she thinks the price of the deal will largely offset the benefits the company accrues.

Four Seasons Go-Private Deal Likely to Succeed
After reviewing the bid tendered for Four Seasons FS last week, Morningstar analyst Jeremy Glaser is increasing his fair value estimate to approximate the buyout price.

The $3.7 billion offer from CEO Isadore Sharp, longtime shareholder Prince Alwaleed, and Bill Gates' Cascade Investments represents a 33% premium to the stock's six-month weighted average price. The deal values the company at over 30 times our estimated 2006 EBITDA per share, much higher than peers such as Marriott International MAR and Starwood HOT, which trade for approximately 11 times EBITDA per share. Although the firm has always traded at a premium, Glaser thinks this offer is especially generous and represents a good deal for shareholders.

Moreover, he thinks the deal will succeed, as CEO Sharp has indicated that the company will not entertain offers from rival bidders, and Sharp, Alwaleed, and Cascade already own around one third of the company, and claim nearly two thirds of the voting power.

Maintaining Georgia Gulf's Fair Value Estimate
Morningstar analyst Ben Johnson dove into Georgia Gulf's GGC third-quarter earnings release last week. While Johnson thinks the near-term picture remains bleak given escalating raw-material prices, the prospect of selling high-cost inventory acquired with Royal Group, and a dismal picture for the North American housing market, he points out that this isn't the first time the firm has faced strong headwinds. Furthermore, management's strict operating discipline coupled with continued rationalization of Royal Group's assets should confer positive cash flows even amid tough conditions in the short term.

The long-term picture remains bright, in his opinion, as the company should enjoy higher utilization across its entire chain of operations once it integrates its legacy chlorovinyl assets with Royal Group's fabricated products operations. As such, Johnson is maintaining his fair value estimate for the company's shares.

Elizabeth Arden Poised for Rebound
Elizabeth Arden RDEN posted fiscal first-quarter results on Friday. Concerns about the possible weakness of prestige fragrances sold in mass retail channels appeared overblown, in Morningstar analyst Lauren DeSanto's opinion, given the firm's healthy 8% sales growth in the channel, which also included the impact of its acquisition of Sovereign brands and its lost distribution of several Unilever UL UN brands.

At department store counters, Elizabeth Arden's brands showed similar strength, led by several new fragrance launches, including Hilary Duff, Badgley Mischka, and a 15th anniversary White Diamonds product launch. The firm seems to have corrected some of its earlier problems with its Prevage launch by moving it to Elizabeth Arden counters in department stores and by introducing a new eye-treatment product.

All told, DeSanto thinks management is making some smart moves in the fragrance category, with acquisitions solidifying its position as a consolidator of prestige fragrance sold at mass retail. Consequently, DeSanto is more convinced that the stock is due to rebound and, thus, is sticking with her fair value estimate.PAGEBREAK

Hansen Natural Reports Third-Quarter Results
Hansen Natural HANS reported third-quarter 2006 results on Wednesday. The company's top-line growth has slowed a bit, and thus, Morningstar analyst Matthew Reilly is lowering his full-year 2006 revenue growth projection to under 70%. However, Reilly thinks that the company's distribution agreement with Anheuser-Busch BUD will make up for the greater-than-expected deceleration this year. Plus, Reilly points out that the company will have a relatively smaller base from which to grow compared with his initial projections.

Judging the top-line potential of a company growing as rapidly as Hansen's is extremely difficult. For that reason, Reilly believes that considering the company's prospects over several years is much more likely to yield the correct valuation than focusing on quarterly or even annual numbers. Although he is currently comfortable with his fair value estimate for Hansen's, Reilly stresses that his valuation is subject to great fluctuation as the growth story plays out, and only very risk-tolerant investors should consider the shares.

Investment Technology Group Posts a Mediocre Third Quarter
Investment Technology Group ITG posted what were, according to Morningstar analyst Patrick O'Shaughnessy, moderately disappointing third-quarter results on Thursday.

Quarterly revenue grew an impressive 43% year over year, but expense growth outstripped the top line, compressing the company's operating margin a tad. Management also announced that October trading volume was down 12% from the prior month. Although O'Shaughnessy believes the firm will continue to take market share, his fair value estimate assumes a few bumps in the road. As such, he's leaving it unchanged for the time being.

Linear Technology Still a Good Value
Linear Technology LLTC reported September-quarter results. Revenue declined slightly from the previous quarter but increased 14% from a year ago. Wireless handsets, automotive, and high-end consumer end markets generated the highest growth, offsetting weakness in telecom infrastructure and industrial end markets.

These trends are consistent with what Morningstar analyst Larry Cao has been seeing elsewhere in the semiconductor industry, so his read is that this does not imply a change in the competitive landscape. Indeed, the company continues to generate margins unrivaled in the semiconductor industry, despite the less-favorable business climate. Cao believes management's focus on profitability will serve long-term investors well. As such, he is leaving his fair value estimate unchanged.

Patience Needed for Maxim Integrated Products Investors
Maxim Integrated Products MXIM reported September-quarter financial results Wednesday. Morningstar analyst Larry Cao's impression: There is little to write home about.

Revenue slowed a tad from a quarter ago but grew 18.5% from a year ago. Management reported strength in volume markets such as digital cameras and flat-panel displays as well as progress in its strategy to partner with major customers. The company continues to focus on complex designs and highly integrated products where it thinks it can add the most value. Cao expects Maxim's technical expertise and growth focus will reward long-term investors when the global economy shows more momentum. He's maintaining his fair value estimate for now.

Apollo Group CFO Resigns
On Friday, Apollo Group APOL announced the resignation of CFO Kenda Gonzales and said it has put chief accounting officer Dan Bachus on administrative leave. After listening to the conference call, Morningstar analyst Kristen Rowland doesn't think the resignation is related to other issues stemming from the way Apollo recognizes revenue or expenses. The company also said it will restate earnings following its investigation into stock-option backdating. Although the magnitude of the restatement is unclear at this point, Rowland doesn't expect it to have a material impact on her fair value estimate, which is based on a future cash-flow stream.

Jeffrey Ptak, CPA, CFA, is a stock analyst with Morningstar. He does not own shares in any of the securities mentioned above.

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