What's in the Bargain Bin Now
17 new stocks hit 5 stars.
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: Below Avg | Price/Fair Value Ratio: 0.86 | Trailing 1-Year Return: 12.2%
What It Does: Atmos Energy (ATO) is the largest natural-gas-only distributor in the U.S., serving more than 3.1 million utility customers. Its utility operations serve Colorado, Georgia, Illinois, Iowa, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Tennessee, Texas, and Virginia. Its non-utility operations market natural gas over a vast U.S. territory and include one of the largest intrastate natural-gas pipeline systems in Texas
What Gives It An Edge: Atmos Energy is the nation's largest utility focused solely on natural-gas distribution, with a growing Texas pipeline division to boot. By diversifying its earnings across 12 states, shareholders are insulated from adverse regulatory rulings in any single state, says Morningstar analyst Paul Justice. Throw in weather-normalized rates in most of the company's jurisdictions, and Justice sees no reason why Atmos cannot build upon its impressive dividend legacy, which includes 94 consecutive quarters of payouts and 23 consecutive years of growth.
What the Risks Are: In Justice's opinion, Atmos poses below-average business risk. Atmos' primary risks include regulatory relationships, the lingering effects of Katrina, and the continued integration of TXU Gas. High gas prices will keep political pressure on the company in all its jurisdictions, making rate increases difficult at best. Also, the company has more leverage than debt-rating agencies like, along with a growing capital-spending program and intentions to maintain dividend increases. The company doesn't have the resources to improve all three areas simultaneously without diluting current shareholders by issuing additional shares.
What the Market Is Missing: Justice believes that Atmos' regulated segments alone present a compelling investment option, but the strong performance of its competitive businesses puts the stock ahead of its peers. With its Texas intrastate pipeline and storage business benefiting from the completion of the North Side Loop project in Texas, and gas marketing benefiting from high and volatile natural-gas prices, Atmos continues to find growth avenues that do not require immense capital expenditures, Justice says.
Electronic Data Systems
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio: 0.77 | Trailing 1-Year Return: 16.1%
What It Does: Founded in 1962 by Ross Perot, Electronic Data Systems provides IT outsourcing (which includes developing and maintaining software applications, computers, and networks), and business process outsourcing (which involves managing internal processes such as human resources). In early 2006, it sold off its A.T. Kearney consulting subsidiary. As one of the largest IT services and BPO firms in the world, its client roster includes both multinational enterprises and government agencies.
What Gives It An Edge: Like most IT outsourcers, EDS' moat comes from its positioning and high switching costs, says Morningstar analyst Mike Ford-Taggart. For instance, one of EDS' services is application software development. When SAP (SAP) or Oracle (ORCL) develop new software, corporate clients are unlikely to purchase it unless it can be serviced. Therefore, software firms must bring EDS in during the software development stage or risk a dearth of corporate sales. EDS basically got a free ride on technology innovation. As for switching costs, most of EDS' revenue is recurring, simply because EDS, having essentially captured a client's IT via the outsourcing agreement, becomes embedded in the chief information officer's decision-making process. Although clients do sometimes change IT service providers, this is relatively rare and incremental. The fact of the matter is, once a decision is made to hire an IT outsourcer, such as EDS, the decision to stay with the outsourcer has also been made. EDS has significant market share among large, multinational corporations (it was spun out of GM (GM) in 1996) and in the government sector
What the Risks Are: Ford-Taggart thinks that EDS poses average business risk. EDS' greatest risk is that the full effect of its turnaround becomes obscured by a deteriorating sales environment. In the third quarter, new contract signings declined versus the year-ago period, though for 2006 as a whole, they were up 32%. Reduced revenues would likely hinder EDS' ability to reach its targeted cost cuts.
What the Market Is Missing: In Ford-Taggart's view, most of EDS' mis-valuation stems from 2002 and 2003, when problem contracts (since renegotiated), accounting errors, and a couple of bankrupt clients wreaked havoc on the company's reported earnings and the stock. Five years later, investors still seem to have a "once bitten, twice shy" attitude toward EDS. The firm is still widely (and incorrectly) perceived as the company that doesn't know how to book revenue properly. This is despite a complete turnover in executive ranks, with new management having significantly turned around the business. Also, the firm has invested heavily in its infrastructure and global delivery network over the past several years, and Ford-Taggart believes some investors are tiring as they await an end to such build-out and its concurrent costs. Lastly, investors continue to favor the non-U.S.-based IT services firms. This overlooks the fact that EDS is positioning itself away from direct rivalry with Indian-based IT firms (via higher-value-added service offerings) and is co-opting the Indian players via acquisition. In short, while the market is focused on past events and future revenue growth, EDS is focused on improving future profitability. The stock trades at under 0.7 times book value. At 5 stars, this stock is a screaming buy for long-term investors, in Ford-Taggart's opinion
Moat: Narrow | Risk: Avg | Price/Fair Value Ratio: 0.77 | Trailing 1-Year Return: 11.7%
What It Does: Ventas (VTR) is one of the nation's largest owners of senior housing and long-term care assets, with more than 500 properties in 42 states, including 197 skilled-nursing homes, 251 independent and assisted-living facilities, and 42 hospitals. Ventas also has investments in other health-care and senior housing facilities.
What Gives It An Edge: Ventas owns one of the best collections of health-care real estate in the country, says Morningstar stock analyst Heather Smith. The company's portfolio primarily consists of independent and assisted-living facilities, which only accept residents who pay out of pocket rather than rely on fickle Medicare and Medicaid for reimbursement. Ventas has also done an exceptional job of identifying properties with great investment returns, Smith adds. The company's return on real estate assets is more than 15%, the highest in our REIT universe.
What the Risks Are: In Smith's opinion, Ventas poses average business risk for one primary reason. Any Medicaid or Medicare budget cuts could take a large toll on former parent Kindred Healthcare's earnings--Kindred derives more than 70% of its revenue from these sources--and impede Ventas' turnaround.
What the Market Is Missing: Ventas has gotten caught up in a sharp sell-off in health-care real estate investment trusts. Year-to-date, the group is down nearly 13% following an impressive run (+45%) in 2006. Profit-taking combined with concerns over rising interest rates has contributed to the sector's decline. Smith believes Ventas, with its conservative balance sheet, is well-positioned to contend with higher interest rates. Plus, she thinks the market has overlooked the strides Ventas has made in improving its portfolio over the past three years. The firm's tenant, geographic, and property-type diversification are impressive, and the company's management team is one of the best in the industry, she says.
Other New 5-Star Stocks
Arthur J. Gallagher & Co. (AJG)
Boston Scientific (BSX)
Liberty Interactive A (LINTA)
Pulte Homes (PHM)
Regions Financial (RF)
Technical Olympic USA
Western Alliance Bancorporation (WAL)
* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, June 29, 2007.
Jeffrey Ptak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.