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Stock Analyst Update

Two 5-Star Spin-Offs Hit the Market

Plus three other new 5-star stocks.

Mentioned: , , , , ,

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.

Covidien
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.73  |  Trailing 1-Year Return: NA

What It Does:  Covidien (COV), formerly the health-care unit of Tyco International, develops, manufactures, and distributes medical and imaging devices, pharmaceuticals, and other health-care products to medical professionals worldwide. The company, through its predecessors, has 140 years of operating history and boasts a direct sales presence in more than 50 countries.

What Gives It An Edge: In Morningstar analyst Alex Morozov's opinion, the foundation of Covidien's narrow economic moat is its vast portfolio of medical devices, ranging from surgical staplers to airway management systems. The company holds leadership positions in many product categories, primarily as a result of a first-mover advantage and massive technological know-how accumulated throughout its extensive operating history. Covidien has a direct presence in more than 50 countries worldwide, and its salesforce of 4,200 representatives is among the largest in the medical device field.

What the Risks Are: Morozov thinks that Covidien poses average business risk. Several operational mishaps over the past two years, including an ill-conceived price increase strategy in its price-sensitive retail product lines, may have damaged the firm's reputation. Now, management's credibility and the future viability of the company depend heavily on the success of its latest technologies and the avoidance of further setbacks. The company is also inheriting the bulk of Tyco's legacy contingencies, including $144 million in unresolved tax liabilities and a long list of outstanding legal proceedings.

What the Market Is Missing: In Morozov's opinion, the market is overly preoccupied with a short-term outlook that calls for a ramp-up in R&D and sales expenditures, resulting in declining EPS. The company is shifting away from a "Tyco cash cow" image and in the process is sacrificing near-term profitability to boost revenue growth, which may be making some investors a bit queasy. Finally, the market may still be hung up on a number of operational issues (capacity shortages and product recalls) that have impacted Covidien over the past two years, as well as poor performance in its retail sector. As long-term investors, we are willing to overlook short-term margin contraction, as we think investment in R&D and sales channel expansion is long overdue. Management's proactive approach should allow Covidien to replenish its product pipeline, which, in turn, should help the firm combat future pricing pressure. Morozov also believes the 2006 mishaps were isolated incidents, and the company has taken adequate measures to address capacity and quality concerns. Finally, Morozov is not overly perturbed with the declining performance in Covidien's retail segment, as he thinks it is only a matter of time before the company gets rid of this business to focus on its more promising and profitable operations.

Discover Financial Services
Moat: Narrow  | Risk: Avg  |  Price/Fair Value Ratio: 0.73  |  Trailing 1-Year Return: NA

What It Does:  Discover Financial Services (DFS) issues credit cards and acquires transactions. It operates a closed-loop credit card network and also uses third parties to issue its cards. Discover extends card loans (receivables) to cardholders who wish to borrow through their credit cards. It also operates a PIN-based (online) debit card network (Pulse) in the U.S. and has a credit card issuing business in the U.K. and credit card acceptance agreements with JCB (a Japanese card firm) and China UnionPay (a Chinese card firm).

What Gives It An Edge: Discover operates a closed-loop credit card network that, in Morningstar analyst Michael Kon's view, would be hard to duplicate. The firm also boasts low attrition rates compared with other card issuers and is planning to grow by teaming up with third-party issuers to issue its cards to their customers. In addition, Discover operates a PIN-based debit card network (Pulse) in the U.S., which makes it a force to reckon with in the growing debit card market.

What the Risks Are: Kon thinks that Discover poses average business risk. Discover depends on securitizations to finance its assets. Any liquidity crisis might put the securitization market on hold, cutting Discover from a major source of funds. Credit quality is another major risk. Although Discover focuses on prime borrowers, credit card losses are usually first to spike in a recession.

What the Market Is Missing: Discover has been under pressure virtually ever since  Morgan Stanley (MS) spun the firm off. Kon believes that this is because some Morgan Stanley shareholders (who now own Discover) aren't interested in owning a pure-play credit card company and therefore are selling their shares in Discover.

For more on Discover, click for director of stock analysis Pat Dorsey's video report.

Talisman Energy
Moat: Narrow  | Risk: Avg  |  Price/Fair Value Ratio: 0.76  |  Trailing 1-Year Return: 13.4%

What It Does: Calgary-based  Talisman Energy (TLM) engages in oil and gas exploration and production, with operations in North America, the North Sea, Southeast Asia, and many other places. In 2006, Talisman produced about 485,000 barrels of oil equivalent per day, weighted 46% to natural gas. The company also reported gross proved reserves of 1.67 billion barrels of oil equivalent.

What Gives It An Edge: Talisman seeks out international oil and North American natural-gas opportunities that provide formidable returns due to premium quality output, low royalty rates, or low operating costs. The company's full-cycle exploration strategy provides a steady supply of new opportunities, and the company can pick and choose which to pursue and which to sell off. That, in Morningstar analyst Kish Patel's view, forms the basis for Talisman's "narrow" economic moat.

What the Risks Are: In Patel's view, Talisman courts average business risk. The most significant risk facing Talisman is a sustained downturn in commodity prices. Reduced commodity prices would hurt cash flows, which would force Talisman to re-evaluate its spending and growth targets. The company also faces risks related to its international exploration and development; for example, the United Kingdom in 2005 increased its petroleum revenue tax from 40% to 50%. Talisman's expansion could be constrained by the need for infrastructure. Changes in environmental regulations could also pose a risk.

What the Market Is Missing: Because of the uncertainty and complexity inherent in its production timelines, country-specific royalty schemes, and pricing realizations, the market may be taking a "show-me-the-money" approach to the stock. Production growth may also appear limited due to recent asset sales. However, Patel expects growth to ramp up over the next few years. Finally, the market may be waiting to find out where incoming CEO John Manzoni plans on taking the company in the future.

Other New 5-Star Stocks
 Avista Corporation (AVA)
 Energy Partners (EPL)

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, July 6, 2007.

Jeffrey Ptak does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.