The Market's Got It Wrong on These 5-Star Stocks
We dig into five firms that recently hit our Consider Buying list.
Following is a roundup 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.
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio: 0.76* | Trailing 1-Year Return: -14.3%
What It Does: Best Buy (BBY) is the largest specialty retailer of consumer electronics in North America, with about 900 stores in the United States and Canada. The company sells a variety of merchandise, including video and audio equipment, personal computers, and home appliances. Best Buy operates electronics stores in Canada and China under the names Future Shop and Five Star, respectively, and specialty stores Magnolia Home Theater, Pacific Sales Kitchen and Bath, and Geek Squad in the United States.
What Gives It an Edge: Morningstar analyst Brady Lemos thinks Best Buy is taking the right steps to differentiate itself from competitors and capitalize on new growth opportunities. By placing specially trained sales associates in customized store environments, Best Buy is able to provide a unique shopping experience unmatched by mass merchants and online retailers. Best Buy is also expanding its Geek Squad computer support service and integrating Magnolia high-end home theater departments into many of its stores. The firm's flexible merchandising platform and willingness to adapt should be valuable assets as the company enters new markets, such as China. Thanks to this differentiated approach to retailing, Lemos believes Best Buy should continue to generate impressive returns on invested capital.
What the Risks Are: Lemos thinks that Best Buy poses average business risk. Best Buy's performance is sensitive to consumer spending, so anything that could pressure shoppers' budgets, such as rising interest rates or geopolitical events, could hurt sales. Expanding into unfamiliar categories such as home remodeling and new markets such as China are also risky propositions for the consumer electronics retailer.
What the Market Is Missing: Consumer electronics retailers have posted generally disappointing results over the past few quarters, and this has forced many of Best Buy's rivals--including Circuit City (CC), CompUSA, and Tweeter--to close a significant number of stores in 2007. As pricing pressure intensifies, Lemos expects Best Buy to further distance itself from its peers and emerge as an even more dominant specialty retailer once consumer spending rebounds. He's especially encouraged by the fact that Best Buy's leading market share is at an all-time high and that customer satisfaction scores are increasing.
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio: 0.73* | Trailing 1-Year Return: -9.2%
What It Does: Navigant (NCI) is a consulting firm that specializes in litigation but also offers electronic data recovery, government contracting, claims management, mergers and acquisitions, and operations advisory services. The company employs approximately 1,900 consulting professionals and works primarily with companies in the financial services, health-care, energy, and insurance industries.
What Gives It an Edge: Navigant is one of only a few large consulting firms in the United States that focuses on helping its corporate customers through the litigation process. When looking for help, these companies' options are limited for a few reasons, says Morningstar analyst Brett Horn. First, with large amounts of money at stake, companies are unlikely to take any chances and look to larger firms, such as Navigant, that have a trustworthy reputation. Additionally, Navigant, with approximately 1,900 consultants, has enough flexibility to quickly tackle even the largest assignments. Finally, through its experience, Navigant has developed long-standing relationships with corporate clients and law firms that help ensure that Navigant is their first call.
What the Risks Are: In Horn's opinion, Navigant courts average business risk. It relies heavily on its senior employees, who manage its customer relationships and provide the expertise that makes the company's services valuable. If a substantial portion of its senior employees left, Navigant would be hard-pressed to replace them quickly, and its results could suffer.
What the Market Is Missing: Horn believes the market is overreacting to a somewhat poor first quarter, in which the company had low consultant utilization rates. However, as the company has to manage almost 2,000 consultants working on a few thousand different projects every year, variation in utilization rates quarter to quarter is inherent to the business and not necessarily a sign of any fundamental decline. Also, the market isn't giving the company any credit for its recent recapitalization, Horn says. The company recently bought back almost 20% of its stock in a Dutch auction and financed this buyback with debt. As the resulting debt load is manageable and the company's shares are trading at a discount to their fair value, he thinks this buyback was a good move.
Moat: Narrow | Risk: Below Avg | Price/Fair Value Ratio: 0.84* | Trailing 1-Year Return: 7.1%
What It Does: Based in Birmingham, Ala., Regions Financial (RF) has $143.4 billion in assets, operates retail and commercial banking businesses, and owns investment brokerage house Morgan Keegan, which made up 18% of the firm's 2006 revenue. With about 2,000 offices, Regions operates in 16 states and is the 10th-largest bank in the U.S.
What Gives It an Edge: Regions Financial, like most banks, possesses a narrow moat, according to Morningstar analyst Jaime Peters. The bank, with $95 billion of deposits, essentially borrows at cheaper interest rates than the government, and then turns around and lends the money back out at much higher rates, earning a spread. Regulation and government subsidies (like FDIC insurance) allow Regions to act as a financial intermediary with low risk and strong profits. In addition, operating in the southeastern United States, Regions' growth opportunities are excellent. The Southeast is rapidly gaining population and wealth, which should translate into higher loan and deposit growth rates, Peters says.
What the Risks Are: Though Peters believes that Regions poses below-average business risk, a few issues are worth noting. Regions has just completed a long and difficult integration with Union Planters and is now jumping into another with one of its biggest rivals, AmSouth. Regions started the Union Planters integration with some major bumps, losing deposits and customers in Union Planters' home state of Tennessee. Regions has since regained the customers, but if history repeats itself with the AmSouth integration, Regions could be hurt.
What the Market Is Missing: Regions and AmSouth are now involved in the long and potentially risky integration process. If the integration goes poorly, Regions will lose customers, and consequently revenues, quickly. While some customer attrition is inevitable during the likely two-year integration process, Peters expects Regions will add new customers to more than offset the losses. Mr. Market, on the other hand, appears to be very pessimistic about Regions' ability to keep or replace its customers, Peters says, allowing shareholders to pick up a decent regional bank at an excellent price.
Moat: Narrow | Risk: Below Avg | Price/Fair Value Ratio: 0.84* | Trailing 1-Year Return: 8.2%
What It Does: SCANA (SCG) is a registered holding company engaged primarily in generating, transmitting, and distributing electricity in parts of South Carolina. It also purchases, transmits, distributes, and sells natural gas in portions of North Carolina and South Carolina. Through a wholly owned subsidiary, SCANA markets natural gas to retail customers in Georgia.
What Gives It an Edge: SCANA collects high returns on capital while keeping customers happy with low electricity bills, says Morningstar analyst Travis Miller. SCANA's fleet of highly efficient nuclear and coal power plants in South Carolina allows it to supply electricity that is far cheaper than market-rate electricity produced from natural gas power plants. SCANA shares some of this profit spread with customers to keep power bills low and captures the rest through regulated rates of return that are among the highest in the U.S. As SCANA builds out its infrastructure to serve one of the fastest-growing populations in the U.S., it will be able to capture these high returns over a much larger capital base and grow profits and dividends at an above-average rate relative to the utility industry, Miller says.
What the Risks Are: SCANA courts below-average business risk in Miller's view. Like most regulated utilities, SCANA's primary operational risk is receiving favorable rates of return from state utility commissions. The company historically has received good treatment from regulators, and Miller expects these relationships to continue protecting the company's downside risk. Long term, SCANA faces risks if demand exceeds its generation supply and it must purchase more electricity in the wholesale market. The company has tried to mitigate this risk by initiating several large generation projects, but the regulatory process can be long and cumbersome.
What the Market Is Missing: Because utility stocks often trade against fixed-income yields in the short run, buying opportunities can develop when the market ignores the significant long-run growth that SCANA should experience during the next decade, Miller says.
Moat: Wide | Risk: Avg | Price/Fair Value Ratio: 0.71* | Trailing 1-Year Return: -30.1%
What It Does: Starbucks' (SBUX) 13,000-plus stores sell coffee, espresso, tea, and cold blended drinks. The stores also offer food, whole bean coffee, coffee-making equipment, music CDs, and other merchandise. The firm sells its coffee (under the Starbucks, Seattle's Best, and Torrefazione Italia brands) and Tazo Tea to grocery stores and warehouse clubs. Through joint ventures and other agreements, the firm produces and sells branded bottled Frappuccino and espresso drinks, ice creams, and liqueurs.
What Gives It an Edge: Starbucks has seized a huge first-mover advantage in specialty coffee retailing by securing more than 9,800 plum locations in attractive U.S. markets (which excludes more than 3,900 stores in 39 foreign countries), says Morningstar analyst John Owens. This provides excellent convenience for its customers. No other specialty coffee retailer has more than 500 domestic units. The company also boasts a very motivated workforce. Starbucks offers its employees an attractive pay package, which includes stock options and health benefits, and ample opportunities for advancement. Because of this, Starbucks can recruit high-caliber employees and retain them for longer, which leads to better customer service, Owens adds. This, along with its high-quality coffee, stylish cafes, and commitment to social responsibility, contributes to the strength of Starbucks' brand, which allows the company to command a premium price for its coffee. Many of its loyal customers routinely purchase their coffee five to seven times per week at their local store.
What the Risks Are: In Owens' view, Starbucks poses average business risk. As the firm continues to penetrate existing markets, same-store sales growth could weaken because of cannibalization. Furthermore, the company is facing increasing competition from the likes of McDonald's (MCD), Dunkin' Donuts, and Tim Hortons (THI). Increases in labor, coffee, and dairy costs could weigh on profits. Starbucks also faces heightened economic, legal, and political risks in international markets like China.
What the Market Is Missing: Market sentiment has turned very negative on Starbucks, with the stock falling 36% from its 52-week high. Same-store sales growth has slowed. Growing competition from McDonald's, Dunkin Brands, and other fast food chains, and a leaked memo from Howard Schultz (worrying about the commodification of the Starbucks' brand), have also stoked market fears. Furthermore, concerns about consumer spending and higher labor and commodity costs have weighed on the shares as well. Owens thinks this has all been priced into the stock and then some. His forecast already calls for domestic same-store sales growth to slow to the low single digits. He believes that fast-food competitors will find it very difficult to match the experience and level of service that Starbucks' customers have grown to love. Owens likes the fact that Schultz remains vigilant about protecting the Starbucks' brand. Also, the macroeconomic pressures will not persist indefinitely, in his view. Finally, he does not believe the market appreciates how much investment is currently flowing through Starbucks' income statement, including the preopening costs, a ramp up in general and administrative costs to support future growth, and a nascent international business. Owens thinks the payback from these investments will lead to more profits and higher returns on invested capital.
Other New 5-Star Stocks
* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, June 22, 2007.
Jeffrey Ptak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.