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Stock Analyst Update

Market Puts Nine New Stocks on Sale

Why we think investors can get a bargain on these names.

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: Wide  |  Risk: Below Avg  |  Price/Fair Value Ratio: 0.82  |  Trailing 1-Year Return: 10.8%

What It Does:  Cintas (CTAS) is the leader of the uniform industry. Boasting more than 700,000 customers, it designs, manufactures, rents, and sells uniforms to businesses in various industries, and roughly 5 million employees in these industries wear its uniforms every day. Cintas also provides ancillary products such as entrance mats, restroom supplies, first-aid and safety products and services, and document-management services.

What Gives It An Edge: Cintas' wide moat is based on large scale advantages, a crucial differentiating factor in distribution businesses. Also important, in Morningstar analyst Joel Bloomer's view, is the size and bargaining power of a distributor's buyers and suppliers. With no customer contributing more than 1% of sales and extensive vertical integration, Cintas is generally the most powerful player in the value chain. The result is an operating margin nearly double that of the closest competitor. It would take enormous missteps by management, exceptional performance by competitors, and probably a decade to unseat Cintas as the dominant force in the industry.

What the Risks Are: Bloomer believes that Cintas poses below-average business risk, meaning that he wouldn't demand a large margin of safety to invest in the shares. Cintas has two outstanding litigation claims by employees that accuse the firm of improper wage and discrimination practices. Although the outcome is currently inestimable, the final verdict could have material financial ramifications and distract management from core operations. Further straining Cintas' relationship with its workers is a unionization effort by a small faction of employees. Still, Bloomer thinks Cintas' stable operating history largely offsets these risks.

What the Market Is Missing: The most likely explanation for undue pessimism is recently weak organic growth and high energy prices. Falling employment in the manufacturing sector as well as slowing overall employment growth mean there are fewer employees to wear uniforms. However, investors with a long-term view should see that Cintas is quickly diversifying into new and growing uniform-wearing industries, such as hotels and casinos, and other route-oriented business services, such as first aid and safety and document management. Over time, Bloomer expects these opportunities to more than offset weak pockets in Cintas' end markets. As for energy costs, Cintas' fleet of trucks and massive washers and dryers consume a large amount of gasoline and natural gas, both of which have become more expensive over the last few years, shaving almost 2 percentage points from Cintas' operating margin. In time, customer price increases and improving profitability in other services should more than compensate for this cost pressure.

Moat: Wide  | Risk: Below Avg  |  Price/Fair Value Ratio: 0.82  |  Trailing 1-Year Return: -13.0%

What It Does:  The Hershey Company (HSY) is the largest North American manufacturer of chocolate and non-chocolate confectionery products. The company markets brands, including Hershey's, Reese's, Hershey's Kisses, Kit Kat, Almond Joy, Mounds, York, Jolly Rancher, Twizzlers, Ice Breakers, and Bubble Yum. The company derives about 10% of its sales internationally.

What Gives It An Edge: In Morningstar analyst Mitchell Corwin's view, the foundation of Hershey's economic moat rests with its collection of iconic confectionery brands, such as Hershey and Reese's, and economies of scale in manufacturing and distribution. No other confectionery company sells as much candy through mass retail channels as Hershey.

What the Risks Are: Corwin thinks that Hershey has below-average business risk. He believes the most significant risks to Hershey achieving its long-term goals come from competition, a mature domestic confectionery market, higher raw-material and commodity costs, and changing consumer preferences for healthier products. Nearly 40% of cocoa beans are grown in the unstable Ivory Coast region of Africa, and prices for sugar and fuel have been quite volatile in recent years. The company attempts to hedge much of its exposure to input costs and increase prices when possible.

What the Market Is Missing: Hershey is ramping up spending on advertising and promotions this year to revive sales of its core brands and generate awareness of new products in different categories, such as dark chocolate. The resulting margin hit from the higher spending and a spike in dairy costs as well as a lack of progress thus far on moving the top line has damped the company's results and punished its shares. Longer term, Corwin believes the higher level of marketing spending will improve sales. But more importantly, he thinks the market is missing the significant margin expansion the company will achieve in the years ahead from a $500 million supply-chain restructuring program that is intended to save it $180 million per year.

Moat: None  |  Risk: Above Avg  |  Price/Fair Value Ratio: 0.62  |  Trailing 1-Year Return: -27.2%

What It Does:  Pantry   is the top independent convenience store operator in the Southeast, with more than 1,490 stores in 11 states. Nearly all stores sell gas; while Kangaroo is the flagship brand name, nearly two thirds of the stores are branded BP, Citgo, Chevron, or ExxonMobil. Pantry stores are primarily located along highly traveled roads in suburban, coastal, and resort markets. The company plans continued store expansion through both construction and acquisitions.

What Gives It An Edge: Most convenience store operators lack economic moats due to their reliance on low-margin fuel sales and the high level of competition. However, in Morningstar analyst Ann Gilpin's opinion, Pantry has gained an edge over rivals via its disciplined, well-executed acquisition strategy as well as its proven ability to ramp up in-store performance. In short, Pantry excels at converting weaker-performing stores in decent locations into high-tech, profitable gems.

What the Risks Are: Gilpin rates Pantry as an above-average-risk company, meaning that she would invest in the shares only at a suitably wide margin of safety to her fair value estimate. Since Pantry operates with significant fixed costs, volatile fuel prices can lead to wild swings in profitability. This risk is exacerbated by the company's high debt level. Also, the execution of the company's growth strategy depends on its ability to improve comparable sales on in-store items and to make accretive, value-creating acquisitions.

What the Market Is Missing: Gilpin thinks the market is being very shortsighted, focusing on shrinking fuel margins, which will likely persist for another 12 to 18 months. But the long-term story is still intact, in her opinion. Pantry is a solid operator with a long track record of making accretive acquisitions. Further, the highly fragmented convenience store industry is ripe for consolidation. Thus, while Pantry will feel the pinch of short-term margin pressure, Gilpin thinks it'll be most painful for small operators. This, in turn, should give Pantry the opportunity to swoop in and acquire these struggling operators at bargain prices. Acquisition success notwithstanding, Pantry's in-store performance is at an all-time high and shows no signs of slowing down. With the addition of car washes and more quick-serve restaurants, in-store margins are set to expand even further over the next few years.

Vulcan Materials Company
Moat: Narrow  |  Risk: Avg  |  Price/Fair Value Ratio: 0.72  |  Trailing 1-Year Return: 54.0%

What It Does:  Vulcan Materials' (VMC) main business is aggregate quarries, which produce stone, sand, and gravel for use mostly in concrete and asphalt. Aggregates make up about 70% of total sales while asphalt and ready-mix concrete make up the balance. The public highway and infrastructure end markets consume nearly half of total production, while the commercial and residential construction markets constitute the balance.

What Gives It An Edge: Morningstar analyst Matthew Warren believes that Vulcan merits a narrow economic moat. Vulcan owns more than 200 well-located rock quarries, which are nearly impossible to replicate as there are numerous barriers to siting, permitting, and constructing a new facility, most notably from would-be neighbors who are less than excited about the potential noise, dust, and truck traffic. Because aggregates only cost about ten bucks a ton and are very expensive to ship by truck, customers face a limited set of choices in many cases. Ongoing large-scale industry consolidation has only served to reinforce an already-favorable pricing environment. Finally, as one of the largest industry players in the U.S., Vulcan benefits from considerable buying power and a degree of flexibility derived from its vast rail and water distribution network.

What the Risks Are: Warren thinks that Vulcan poses average business risk and, thus, would demand a moderate discount to his fair value estimate to invest in the shares. As residential construction and related activity slows, Vulcan's volume growth has temporarily turned negative. Offsetting this concern are improvements in infrastructure and commercial construction markets and ongoing price gains. Though fairly well diversified, Vulcan is highly exposed to construction activity in California.

What the Market Is Missing: Vulcan is currently facing the most dismal industry environment in years in terms of shipments, as volumes are dropping at a double-digit clip due to the substantial decline in new home construction. It would be even worse without the impressive growth currently being enjoyed by infrastructure and nonresidential construction customers, which make up the majority of sales by end market. Lost business also deleverages the firm's cost structure, as many of the costs involved in operating a quarry are largely fixed. Considering all of these factors, the unfamiliar might expect declining profitability. On the contrary, with aggregate prices up nearly 15% versus last year, the firm expects gross margins to improve by 3 percentage points and for earnings per share to grow in the midteens in the second quarter. While it's likely that this year could mark the crescendo in terms of pricing gains, Warren expects Vulcan to be able to price ahead of inflationary pressures over the next several years, which should lead to further margin expansion, especially when shipments begin to stabilize. The main drivers of pricing power in the industry are dramatically higher land prices--which make alternative forms of development more profitable, especially near urban centers--and increasingly expensive imports, which create a new pricing floor for coastal markets. While the current price/earnings multiple on Vulcan's shares might appear high, substantial profit growth will reverse this situation with the passage of time.

WCI Communities
Moat: None  |  Risk: Above Avg  |  Price/Fair Value Ratio: 0.62  |  Trailing 1-Year Return: -7.8%

What It Does:  WCI Communities  designs, builds, and sometimes manages leisure-oriented master-planned luxury communities. Major markets include Florida, the Mid-Atlantic states, and the Northeast. Product offerings range from $200,000 to $9 million-plus, with the average selling prices sitting at $677,000 for traditional homes and $1.3 million for tower residences in 2006. WCI also offers real estate services, amenity memberships, and land sales. Total sales were $1.8 billion in 2006.

What Gives It An Edge: In Morningstar analyst Eric Landry's view, WCI lacks an edge, as it's a condo developer concentrated in an overcrowded Florida market. That area has been hit hard and is currently in the midst of a substantial inventory glut. The company may have some brand recognition, as the WCI name is pretty well known as an ultra-luxury tower developer. But in a falling price environment, that advantage will carry the only company so far.

What the Risks Are: Landry believes that WCI courts above-average risk. Consequently, he'd invest in the shares only at a sharp discount to his fair value estimate. WCI derives almost 90% of its revenue from Florida, one of the most overbuilt and least affordable regions in the country, meaning that demand will probably be soft for some time. This is problematic, considering that the company is carrying a substantial amount of debt and derives significant revenue from the noncash percentage-of-completion recognition method in its tower business. If cancellations continue to rise, debt covenants will come into play.

What the Market Is Missing: The stock is cheap in Landry's opinion, as its tangible book value of over $21 per share should provide a reasonable approximation of the upper end of its intrinsic value range. The market is apparently focused upon the company's large receivables balance and a large and cumbersome debt load. In addition, at least some investors frown upon the company amid an overall distaste for builders in general. Landry is also concerned, explaining his above-average risk rating for the company. That said, there's been conditional interest in the company from Carl Icahn's group at $22 per share, an offer the board turned down in favor of an orderly sale process. Landry thinks it's likely that a deal will get done at a price ranging from the high teens to the very low $20s.

Other New 5-Star Stocks

 J.P. Morgan Chase & Co. (JPM)
 Old National Bancorp (ONB)
 Old Republic International (ORI)

* Price/fair value ratios calculated using fair value estimates and closing prices as of Friday, July 20, 2007.

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