Two Retailers on the Bargain Rack

Following is a sampling of stocks that recently jumped to 5 stars. By way of background, we award a stock 5 stars when it trades at a suitably large discount--i.e., a margin of safety--to our fair value estimate. Thus, when a stock hits 5-star territory, we consider it an especially compelling value.

To get a  complete tally of stocks that have recently jumped to 5 stars--as well as our  full list of 5-star stocks--including our consider buying and selling prices, risk ratings, and moat ratings--simply take Morningstar Premium Membership for a test spin. Click here to sign up for a free trial.

Lowe's Companies
Moat: Wide  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.84*  |  Trailing 1-Year Return: 3.6%

What It Does:  Lowe's Companies (LOW) is the second-largest home-improvement retailer in the world and operates approximately 1,400 warehouse-format stores throughout the United States. The company's stores offer products and services for home decorating, maintenance, repair, and remodeling. Lowe's targets retail do-it-yourself and do-it-for-me customers, as well as commercial business clients.

What Gives It an Edge: Thanks to substantial buying power and efficient store operations, Lowe's consistently earns returns on invested capital well in excess of its cost of capital, and Morningstar analyst Brady Lemos expects that trend to continue in the future, explaining why he has awarded the company a "wide" economic moat. Lemos thinks Lowe's offers consumers a compelling reason to shop its stores rather than those of other home-improvement retailers, including  Home Depot (HD). He believes Lowe's has excelled in customer service and shopping convenience by keeping stores well staffed and designing intuitive store layouts, among other customer-focused initiatives. Not surprisingly, Lowe's routinely outshines Home Depot in customer satisfaction studies.

What the Risks Are: Lowe's sales are closely tied to the U.S. construction market. Further softening of the housing market could reduce sales and profitability. Additionally, Lowe's faces the prospect of market saturation as its domestic footprint approaches 1,500 stores and competitors like Home Depot continue to expand.

What the Market Is Missing: Near-term concerns regarding the housing market have created a good opportunity to invest in this high-quality retailer, in Lemos' opinion. While housing market worries could pressure sales over the next few quarters, Lemos likes Lowe's long-term prospects and expects the retailer to continue to gain share of the fragmented home-improvement market. In particular, Lemos believes Lowe's can leverage its industry-leading customer service, shopper-friendly stores, and proven business model to profitably expand domestically and abroad. And with just a 7% share of the U.S. home-improvement market, Lowe's still has plenty of room to expand, particularly in the quickly growing installation-services segment. Furthermore, Lowe's stores' superior shopping experience allows them to prosper even in locations where they overlap with other home-improvement retailers.

For more on Lowe's, watch our video report.

Sears Holdings
Moat: None  |  Risk: Average  |  Price/Fair Value Ratio: 0.75*  |  Trailing 1-Year Return: 13.8%

What It Does:  Sears Holdings  is the third-largest retailer in the U.S. It operates around 3,900 full-line and specialty stores in the U.S. and Canada both in malls and off the mall, in big-box stores. It sells an assortment of consumables, apparel, appliances, tools, home furnishings, and consumer electronics. Sears Holdings' proprietary brands include Kenmore, Craftsman, Lands' End, and DieHard.

What Gives It an Edge: With little investment in its stores, declining market share, and no clearly articulated turnaround strategy, Morningstar analyst Kimberly Picciola finds it hard to believe Sears is going to stage a comeback as a retailer. But Sears is not your typical retailer. Eddie Lampert, a hedge fund manager with a stellar record of allocating capital, has a 42% stake in the company, serves as chairman of the board, and has been granted the authority to invest the company's surplus cash. While Lampert has stated his intent to turn the retail business around, Picciola thinks the value in this company is elsewhere: Lampert's ability to invest the surplus cash, the value of the firm's real estate, and the proprietary brands. Over the next 10 years, Picciola believes Lampert will milk the company's retail business for cash and eventually sell the firm's real estate. Around 45% of our fair value estimate comes from the company's real estate assets, while cash flows from the retail business, the premium for having Lampert at the helm, and the brands account for 24%, 23%, and 8%, respectively.

What the Risks Are: We think about this company's risks in terms of the four parts of the valuation. Picciola considers the risk of turning around the retail business to be above average and Lampert's ability to generate returns in the ballpark of 20% over the next 10 years to be speculative. However, Picciola views the risk associated with unlocking value in the company's real estate and its brands as average. Picciola weights the risk ratings similarly to the way the four parts contribute to the valuation. This gives an overall risk rating of average. Despite that, Picciola is making some big assumptions. First, she assumes the company will monetize its assets, but she has seen no signs since the merger that Sears Holdings intends to sell its real estate. Second, she expects the company's market share to modestly decline. Should it drop off a cliff, Lampert may be forced to liquidate the real estate at a less favorable price. Third, if consumer spending plummets or the commercial real estate market tanks, Sears will have to fall back on its underperforming retail business.

What the Market Is Missing: While Sears is focused on improving profits and sales at its Kmart and Sears stores, Picciola continues to believe this is more than just a retail turnaround story. Given the presence of Lampert, who has an exceptional record of making money, Picciola believes it is prudent for our valuation to look beyond the cash flows generated from the retail business and consider other factors, like the company's real estate assets and the cash available for investing. The market, it seems, is either overly fixated on the state of the retail business, or is discounting the value that could ultimately be attributable to the company's real estate or Lampert's investments of the firm's cash.

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, June 1, 2007.